Welcome to Part 8 of Mining Man’s Mining Financial Basics series.  In this part we are looking at a specific component of a mining company’s financial evaluation methods – the Weighted Average Cost of Capital, or WACC for short.  We are going to look at what WACC is, why we need it, and how it is calculated.

To fully understand why we need WACC, it is important to brush up on the concepts of time value of money and discounted cash flow.  You can link back to these earlier topics in our series here and here.
 

Recap of Discounting Rate

In our earlier discussions of how to evaluate a mining project, we talked about a discounting rate that would be applied to all future cash flows in order to make them “equivalent” to today’s cash flows.  This was based on the principle of time value of money which says that a dollar today is worth more than a dollar tomorrow.

We discussed how a company would select a discounting rate to use in their financial modelling based on the risks inherent in the project or industry as a whole.  We also said that this discounting rate is effectively equivalent to the rate of return the company needs to get on their investment to make it worthwhile for the risk they are taking.

What we are now interested in is a further investigation of how a company will actually determine what discounting rate to use in their financial evaluations.  The rate they most commonly choose to use is the Weighted Average Cost of Capital (WACC).
 

How is WACC Calculated?

The WACC is exactly what its name suggests – it is the weighted average of the costs a company has to pay for the capital it uses to make investments.

A mining company needs money to make all the investments it wants to make, whether that be building new mines, expanding existing operations, or buying pieces of equipment.  The money they use to make these investments is called capital.  Normally a company doesn’t have enough capital available from the cash they make from their existing operations, so they need to borrow or source it from elsewhere.  Mining companies source capital from a range of different sources, but the two main categories are by equity or debt. 

Equity is usually money obtained from selling shares in the company.  An investor will give the company money in return for a share of the company itself.  The company is not usually obliged to make any interest payments on this capital, but most will pay dividends to their shareholders depending on the profit they have made in a particular period.  The shareholder also benefits from the value of the company (and hence the value of their shares) increasing over time.

Debt is money the company borrows and has to pay interest on, just the same as we might borrow money from the bank.  The company will then have to pay interest each year which will be a set percentage of the amount they have borrowed.  They need to make these repayments no matter what, whether they make a profit or not.  However the amount of debt doesn’t increase over time like the value of the company does.

For each source of capital that the company uses, there will costs associated with having access to this capital.  For equity the company needs to make dividends repayments and also has other costs involved with managing the shares themselves.  With debt, regular repayments are required based on the interest rate.

We can therefore work out what percentage of the capital the company has to pay out each year in order to service or pay for this capital.  For debt this percentage is easy to calculate as it is basically the interest rate, for equity it is a little more difficult but companies will easily be able to work it out.

So a company will work out what “rate” it is paying out for each individual source of capital that it has.  A company at any one time will probably have numerous sources of both debt and equity capital, all at different rates. 

    

The weighted average cost of capital then is basically the average of all the rates the company is paying on all its different capital source.  The average is actually a weighted average, meaning that each individual rate is weighted more or less according to the amount of capital being paid for at that rate.   

So to calculate their WACC, a company looks at all its different capital sources and works out the average rate it is paying to service these sources, weighting each rate by the size of the capital from than source.


How is WACC Used?

As mentioned in the first section of this article, WACC is used as the discounting rate applied to future cash flows when doing financial modelling or when working out a Net Present Value.

The WACC rate is usually used directly as the rate used to discount future cash flows.  Sometimes a company will apply a modifying factor to the WACC to account for increased risk in certain projects.  For instance, some more risky projects may attract use a discounting rate equal to the WACC plus 2-3%.

By using this rate as our discounting rate, we are effectively saying that our project needs to make a higher return than what we are paying to our investors in order to be viable.

And this makes perfect sense – any project we are investing borrowed or shareholders money in definitely needs to make us more than what we are paying out to those investors. 

For example if our WACC worked out to be 9% (i.e. on average we pay $9 a year for every $100 someone has invested in us), then our project would need to make at least 9% to break even and be viable.  By using 9% as our discounting rate, we are getting a real idea of exactly how much value we will be earning from the project once we have paid off all our investors.
 

Summary

WACC is a reasonably straightforward concept for us to understand.  We don’t need to be able to calculate it, and in fact the calculations behind the number can be quite complex.  Working out the cost of debt is easy, but working out the cost of equity is quite difficult.  The calculation is also made more complex by the fact that interest costs on debt are usually tax-deductible whereas costs of equity (i.e. dividends) may not be.

But all that complicated calculation aside, it’s important for us to know roughly what our company’s WACC is – anyone in the finance team should be able to tell you (hopefully).  This will give you an indication of how much return project investments need to make to be viable, and also tell you what discounting rate is probably being used in financial evaluations at your company.

     

Click here to move on to Part 9 of this series, looking at Budgets and Forecasts.


- Jamie Ross
Mining Man  - Great Safety, Leadership and Productivity Ideas for the Mining Industry

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