Energy Affordability - WACC and CAGR
Energy Affordability - WACC and CAGR
WACC, CAGR
Contents
Introduction
WACC
WACC Example
CAGR
CAGR Example
Applications To The Energy Sector
Concluding Remarks
Bitesize Edition
There have been many examples, especially in nuclear energy, of projects experiencing cost and schedule overruns. As a result, I’ve decided to explore affordability metrics, today covering WACC and CAGR.
As well as an example for each, I’ve then applied both these metrics to applications within the energy sector. How can the proportion of debt capital and equity capital used in a project affect a project’s affordability? How can WACC and CAGR work together to indicate which projects will provide shareholders with value? Find out more below!
Introduction
Previously I’ve discussed net present value and the internal rate of return. If these posts interest you I’ll link them here!
For today, let’s commence the exploration into WACC and CAGR.
WACC
The weighted average cost of capital refers to a company’s average cost of capital after tax. This includes all sources, including common stock, preferred stock, bonds, and any other form of debt. It’s the percentage rate that a company can expect to pay to finance its business activities. Shareholders, bondholders, and other stakeholders can utilize the metric to analyse if the capital provided to the company will see them gain their desired rate of return. Let’s take a look at the equation to better picture this.
The first key takeaway is that we’re exploring the cost of each capital source as a percentage of the total capital.
The fraction E/V refers to the proportion of the company financed by equity, and D/V is the proportion of the company financed by debt. These figures are called the weighted value of equity capital and the weighted value of debt capital respectively. The sum of total equity and total debt is the total cost of capital. As a result, the equation below should always hold:
If the equation doesn’t hold, check you haven’t missed some debt or equity financing in your calculation.
As an aside, for anybody interested, we can calculate the debt-to-equity ratio with these metrics, which can be used to assess the financial leverage of a company. A good ratio is considered as a figure below 2. In context, this would be a company with debt that is double its equity. So, the company has £2 of debt for every £1 of equity. When looking at the financial statements, take total liabilities and total shareholder’s equity from the balance sheet to calculate this ratio.
A final aside, remember equity is assets plus liabilities. If not explicitly given the equity in an example, if you have the assets and liabilities, you can still complete the equation. Now, let’s go back to WACC with a calculation.
WACC Example
Debt = £1,000,000
Market Cap/Equity = £4,000,000
Minimum Return Shareholders Demand = 20%
Corporate Tax Rate = 25%
Cost of Debt = 5%
We then sum the two aspects of WACC:
Hence, this figure is the cost of capital and will be the minimum return investors will want to justify their investment.
For a proper analysis using WACC, compare this WACC to other companies in the sector. Also, consider the structure of the business. At what stage of the company cycle is the company? The differences in capital structure between a startup and an established company must be considered in the context of WACC.
CAGR
The compound annual growth rate is the rate of return required of an investment for it to grow from a balance at the beginning to an aspired balance at the end of the investment’s life span. The figure assumes profits are reinvested at the end of each period.
The equation is as follows:
EV is the end value of an investment. BV is the beginning value of an investment, and n is the number of years.
This will provide us with a rate at which an investment would grow if it grew at the same rate every year. However, the discount rate and time value of money are not accounted for when using CAGR. Still, let’s explore an example.
CAGR Example
Initial Investment = £10,000
Year 1 Return = 30%. Portfolio Value = £13,000
Year 2 Return = 20%. Portfolio Value = £15,600
Year 3 Return = 10%. Portfolio Value = £17,160
One advantage of CAGR is that it smoothes investment returns over the considered period. It can also include years of negative growth, and compare investments in different asset classes.
Again, it’s important to assess CAGR in relation to other companies or projects in the same sector. A CAGR of 25% in an industry with an average of 30% looks weak. But an industry average of 10% and a company with a 25% CAGR looks great.
Note, that a negative CAGR can be calculated, and this indicates losses over time. These projects or investments aren’t worth pursuing at all.
Unfortunately, CAGR does nothing to assess the volatility of an investment. To account for this drawback, CAGR can be used in the MAR ratio, which adjusts for risk. The MAR ratio divides the CAGR by its most significant drawdown. For example, a 20% CAGR with a 50% drawdown will have a MAR ratio of 0.2:0.5, or 0.4. The higher the MAR, the better the returns when accounting for risk.
When CAGR can be most useful is when it’s used to calculate a hurdle rate of return. This is the lowest rate of return a project can achieve for it to be deemed “acceptable” by a manager or investor.
For example, if you know you need £1,000,000 for an energy project in 10 years, and you have £200,000 today, you can calculate what your average rate of return should be to reach your objective.
If an investor thinks that they can achieve an 18% return a year, they can reverse engineer the CAGR equation to figure out how much to invest initially to achieve their goal.
Typically, a higher hurdle rate implies a riskier project. WACC can also be utilized as a hurdle rate.
Applications To The Energy Sector
When considering energy companies, the sector is very capital-intensive. Investment in infrastructure is large, energy exploration is costly, and technology has advanced within the sector. As a result, debts can be large, especially early on in the life of a company when equity doesn’t come as easily.
The proportion of debt capital to total capital allows us to assess the financing of these energy projects. A nuclear power plant could be necessary in our world for baseload power moving forward as we try to clean up the world, but a higher WACC can indicate higher risk or financing costs. An analysis such as this can determine if an energy project is worth pursuing. The cost of commodities, regulatory issues, or geopolitical tensions, can also be reflected in the cost of equity via stock market price changes, or the cost of debt through higher interest payments in tighter financial conditions. In short, WACC certainly has its uses.
The best combination of WACC and CAGR comes when calculating the hurdle rate, specifically for investments in energy projects. If the expected return is larger than the WACC, then it could be considered a viable project. We can then move on to using the internal rate of return or net present value to compare different projects with CAGR > WACC. This is especially useful when comparing different sources of energy, for example, oil and gas projects versus renewable projects, which can usually be difficult to compare.
As discussed previously, we can adopt a worst-case scenario approach when it comes to debt costs, electricity produced, or the cost of electricity for consumers. We could also assume a lower rate of return here, or a higher corporate tax rate. If a project still has a CAGR that is higher than WACC, it will weather tougher conditions.
CAGR can be used to assess affordability, but it has alternative uses. It can be used to analyse raw energy production in a project, to see if it’s growing as expected, or to assess the market share of a particular energy source within the overall sector. We aren’t limited to financial growth here, we can use CAGR to assess growth in other areas of our energy projects.
Concluding Remarks
A CAGR that is higher than WACC can indicate value is being created for shareholders. WACC can discount future cash flows, and CAGR can predict future revenue growth. Revenue via CAGR being higher than the cost of capital via WACC is a simple, but useful metric. When used together, it can be explored if these long-term decisions contribute positively to a company, and create value for investors while accounting for the costs.
If my analysis of affordability metrics has confirmed anything, it’s that these metrics in isolation have little use and can be misleading. However, when used together, and compared to other projects, they can act as a filtering system. Remove the projects that won’t return more than the WACC, those with a negative NPV, or an IRR less than the expected project return, and you’ll possess a smaller list of viable projects. Especially in the West, energy projects have seen cost overruns. These metrics need to be used before then moving onto analysing other characteristics, such as efficiency, resource availability, and environmental impacts, among others.
This concludes my exploration of specific metrics in energy affordability. Next week, I’m going to explore the effects of tariffs and subsidies, before ending this miniseries by exploring metrics that consumers can use to understand their personal energy affordability. Look out for that over the coming weeks!
Thanks for reading! I’d greatly appreciate it if you were to like or share this post with others! If you want more then subscribe on Substack for these posts directly to your email inbox. I research history, geopolitics, and financial markets to understand the world and the people around us. If any of my work helps you be more prepared and ease your mind, that’s great. If you like what you read please share with others.
Key Links
The Geopolitics Explained Podcast
If you want to see daily updates and discover other newsletters that suit you, download the Substack App.
You can become a paid subscriber to support my work. There are long-form monthly articles in my global questions series exclusively for paid subscribers. Read Geopolitics Explained for 20p per day or start a free trial below to find out if my work is for you! I appreciate your support!
Sources:
https://www.investopedia.com/terms/w/wacc.asp#:~:text=Weighted%20average%20cost%20of%20capital%20(WACC)%20is%20a%20company's%20average,pay%20to%20finance%20its%20business.
https://www.investopedia.com/terms/c/cagr.asp
https://www.investopedia.com/terms/m/mar-ratio.asp
https://www.investopedia.com/terms/h/hurdlerate.asp
https://www.investopedia.com/terms/d/debtequityratio.asp#:~:text=%2FE)%20Ratio%3F-,The%20debt%2Dto%2Dequity%20(D%2FE)%20ratio,important%20metric%20in%20corporate%20finance.