What Is the Relationship Between WACC and ROIC?

Companies require capital to fund their operations and growth. This capital, whether from shareholders or lenders, is not free, as providers expect a return on their investment. To gauge a company’s financial health and its ability to generate value, analysts use specific financial metrics. Two of the most insightful measures are the Weighted Average Cost of Capital (WACC) and Return on Invested Capital (ROIC), which offer distinct perspectives on a company’s performance.

Understanding Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) represents the average rate of return a company is expected to pay to all its capital providers, including both equity shareholders and debt holders. Think of it as the blended cost a company incurs to finance its assets. The calculation itself is a blend of the costs of different types of capital, weighted by their proportion in the company’s financial structure.

The formula for WACC is: WACC = (E/V Re) + [(D/V Rd) (1 – T)]. In this formula, E represents the market value of the company’s equity, and D is the market value of its debt. V is the total value of the company (E + D), Re is the cost of equity, Rd is the cost of debt, and T is the corporate tax rate.

The cost of equity (Re) is the return that shareholders require for their investment in the company. Since this is not a fixed payment, it is estimated using financial models. The most common method is the Capital Asset Pricing Model (CAPM), which considers the risk-free rate of return, the stock’s beta (a measure of its volatility relative to the market), and the expected market return.

The cost of debt (Rd) is the effective interest rate a company pays on its borrowings. This can be found by looking at the interest expenses on a company’s income statement and the total debt on its balance sheet. A feature of debt financing is the tax shield. Because interest payments are tax-deductible expenses, they reduce a company’s taxable income, and the (1 - T) part of the formula accounts for this tax benefit.

For example, consider a company with a capital structure of 60% equity and 40% debt. If its cost of equity is 10%, its cost of debt is 5%, and the corporate tax rate is 21%, the WACC would be calculated as follows: (0.60 0.10) + [(0.40 0.05) (1 – 0.21)]. This results in a WACC of 7.58%, representing the average cost the company pays to finance its operations.

Understanding Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) is a profitability ratio that measures how effectively a company uses the capital invested in its operations to generate profits. Unlike other profitability metrics, ROIC focuses on the returns generated by all capital providers, both debt and equity, offering a holistic view of operational performance. A higher ROIC suggests a more efficient use of capital.

The formula for ROIC is: ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital. Both NOPAT and Invested Capital are calculated using specific figures from a company’s financial statements to ensure the measurement is focused purely on operational efficiency.

NOPAT represents a company’s potential cash earnings if it were financed entirely with equity and had no debt. It is calculated as Earnings Before Interest and Taxes (EBIT) multiplied by (1 – the corporate tax rate). Using NOPAT removes the effects of how a company is financed, providing a clearer view of its core operational profitability.

Invested Capital is the total amount of money raised by the company from its shareholders and debt holders that is used to fund its operations. It can be calculated from the balance sheet by summing the company’s total debt and total equity and then subtracting any non-operating assets, such as excess cash and cash equivalents.

To illustrate, imagine a company reports an EBIT of $500,000 and has a 21% tax rate. Its NOPAT would be $500,000 (1 – 0.21), which equals $395,000. If the company’s balance sheet shows total debt of $1 million and total equity of $1.5 million, and it holds $100,000 in excess cash, its invested capital would be ($1,000,000 + $1,500,000 – $100,000), or $2.4 million. The ROIC would then be $395,000 / $2,400,000, resulting in an ROIC of 16.46%.

The Relationship Between WACC and ROIC

The comparison between WACC and ROIC is central to value creation analysis. WACC represents the cost a company incurs to fund its operations, setting a minimum rate of return, or a “hurdle rate,” that the business must exceed. ROIC measures the actual return the company is generating from its investments. The difference between these two metrics, often called the “spread,” reveals whether a company is creating or destroying value for its investors.

When a company’s ROIC is greater than its WACC, it signifies that the returns generated from its projects exceed the cost of the capital used to fund them. This positive spread indicates that the company is creating value for its investors. For instance, if a company has an ROIC of 12% and a WACC of 8%, it is generating a 4% return above its cost of capital, which increases company value.

Conversely, if a company’s ROIC is less than its WACC, the business is not generating sufficient returns to cover its capital costs, which leads to value destruction. A company with an ROIC of 6% and a WACC of 9% is losing 3% on every dollar it has invested. This situation is unsustainable and signals potential issues with the company’s operational efficiency or strategic investments.

In the case where ROIC is equal to WACC, the company is earning just enough to satisfy its capital providers. While it is not destroying value, it is not creating any new value either. The business is essentially treading water, covering its costs but failing to generate the excess returns that drive long-term growth and shareholder wealth.

Application in Business Analysis

The relationship between ROIC and WACC has a practical application in business analysis through a metric known as Economic Value Added (EVA). EVA translates the percentage spread between ROIC and WACC into a tangible dollar figure, representing the amount of wealth a company created or destroyed during a specific period.

The formula for EVA is: EVA = (ROIC – WACC) x Invested Capital. This calculation takes the value-creation spread and applies it to the total capital base of the company. A positive EVA indicates that the company has generated wealth above and beyond its cost of capital.

Building on the previous examples, consider a company with an ROIC of 16.46%, a WACC of 7.58%, and invested capital of $2.4 million. The spread (ROIC – WACC) is 8.88%. The EVA would be calculated as (0.1646 – 0.0758) $2,400,000, which equals $213,120. This positive figure shows the dollar amount of economic value the company created.

Analysts and corporate managers use EVA to assess performance and guide strategic decisions. It helps in evaluating the profitability of different divisions, assessing the viability of new projects, and structuring executive compensation plans. If a project is expected to generate a return lower than the WACC, it would result in a negative EVA, signaling that the investment would destroy value and should be avoided.