Daily study of economics, management, and finance

September 29, 2026 (KST) · Day 9
Today's topic: The minimum return a company must exceed — Understanding WACC and the ROIC spread

1. Review of the previous lesson

In Day 8, we measured how much after-tax operating profit a company generates from capital committed to operations using ROIC = NOPAT ÷ Average invested capital. Today, we study the benchmark for deciding whether ROIC is sufficiently high and the rate used to discount future cash flows to present value: WACC as today's topic.

2. Today's key concept

WACC (Weighted Average Cost of Capital) is the average return required by shareholders and creditors, weighted by the company's capital structure.

\[ WACC = \frac{E}{D+E}\times R_e + \frac{D}{D+E}\times R_d\times(1-T) \]

• \(E\): Market value of equity, generally market capitalization
• \(D\): Market value of interest-bearing debt
• \(R_e\): Cost of equity
• \(R_d\): Pre-tax cost of debt
• \(T\): Applicable corporate tax rate

WACC is the minimum return that a new corporate investment should exceed—the hurdle rate—and a standard discount rate for converting free cash flow to the firm (FCFF) into present value.

\[ ROIC>WACC \Rightarrow \text{Economic value creation} \]

\[ ROIC<WACC \Rightarrow \text{Economic value destruction} \]

Crucially, WACC is not a definitive figure printed in financial statements. Analysts estimate it using disclosed figures and market data.

3. Concept explained

3-1. Cost of capital is a required return, not an accounting expense

Using capital requires compensating its providers.

• Banks and creditors require interest payments and principal repayment.
• Shareholders require expected returns including share-price appreciation as well as dividends.

Interest expense appears on the income statement, but the cost of equity does not. Shareholders have an expected return even without dividends because they bear risk in providing capital.

WACC is therefore better understood as the following, rather than an accounting expense actually paid:

What average return do creditors and shareholders require to provide capital while bearing this company's risk?

For example, a 9% WACC implies that, over the long term, the company must earn at least 9% on invested capital to meet capital providers' required returns.

3-2. The overall structure of WACC

The basic formula is:

\[ WACC = \text{Equity weight}\times\text{Cost of equity} + \text{Debt weight}\times\text{After-tax cost of debt} \]

More explicitly:

\[ WACC = \frac{E}{D+E}\times R_e + \frac{D}{D+E}\times R_d\times(1-T) \]

In principle, equity and debt weights should use market values rather than book values as the basis.

For equity, market capitalization can be calculated from current share prices. Debt should also use market value when observable, as with listed bonds; in practice, book debt is sometimes used as a proxy when information is limited.

3-3. How is the cost of equity estimated?

The cost of equity is not a fixed interest rate promised to shareholders. It is generally estimated using CAPM.

\[ R_e = R_f+\beta\times ERP \]

• \(R_f\): Risk-free rate
• \(\beta\): The stock's sensitivity relative to the market
• \(ERP\): Equity market risk premium

① Risk-free rate \(R_f\)

Use the yield on government bonds with very low default risk.

Long-term business valuations generally use a long-term government bond yield in the same currency as the valuation.

• Valuing KRW cash flows → KRW risk-free rate
• Valuing USD cash flows → US dollar risk-free rate

Do not mix currencies, such as discounting dollar cash flows using Korean-won government bond yields.

② Beta \(\beta\)

Beta is a statistical estimate of how sensitively a stock has responded to movements in market returns.

• Beta of 1.0: Sensitivity similar to the market
• Beta of 1.3: Potentially greater volatility than the market
• Beta of 0.7: Potentially lower volatility than the market

Beta is estimated from historical stock prices and varies with the measurement period and benchmark index. Temporary price spikes or drops and changes in capital structure can also distort it.

If capital structure has changed substantially, or when valuing an unlisted business unit, remove debt effects from peer-company betas to estimate unlevered beta and then relever it using the target company's target capital structure.

③ Market risk premium \(ERP\)

The market risk premium is the additional return investors require for investing in equities rather than risk-free assets.

\[ ERP = \text{Expected market return}-\text{Risk-free rate} \]

ERP represents future expected returns and is not directly observable. It is estimated using historical returns or expectations implied by market prices, and may vary by institution, market, and date.

A simple CAPM example

Assume a 4% risk-free rate, beta of 1.2, and a 5% market risk premium:

\[ R_e = 4\%+1.2\times5\% = 10\% \]

The company's estimated cost of equity is 10%.

3-4. The cost of debt can differ from historical borrowing rates

The cost of debt \(R_d\) is the interest rate a company is expected to pay on new borrowing or bond issuance today.

Relevant information includes:

• Corporate bond yields to maturity
• Recent corporate bond issuance yields
• Rates on new bank loans
• Market yields by credit rating
• Disclosed weighted-average borrowing rates
• Rates and maturity profile of existing borrowings

Even if bonds issued previously at 3% remain outstanding, when newly issued bonds of the same risk yield 6%, that current opportunity cost of 6% may be more appropriate for valuation.

However, with long-term fixed-rate borrowings, higher market rates do not immediately raise current cash interest expense. Distinguish these two concepts:

• Current accounting interest expense: Interest actually paid under existing debt contracts
• Cost of debt in WACC: The current market-required opportunity cost of debt

3-5. Why adjust the cost of debt for taxes?

Interest expense is generally tax-deductible and can reduce taxable income. This is called the tax benefit of interest or tax shield.

\[ \text{After-tax cost of debt} = R_d\times(1-T) \]

With a 6% pre-tax cost of debt and a 25% corporate tax rate:

\[ \text{After-tax cost of debt} = 6\%\times(1-25\%) = 4.5\% \]

However, the tax shield should not be applied mechanically in some situations:

• The company persistently reports pre-tax losses
• Interest deductibility limits apply
• Tax laws differ across countries
• Loss carryforwards eliminate current tax payments
• Interest on particular borrowings is not tax-deductible

Verify whether the company can actually use the tax benefit.

3-6. Does adding debt keep reducing WACC?

The cost of debt is generally lower than the cost of equity.

Reasons include:

• Creditors rank ahead of shareholders for repayment.
• Interest is paid under contractual terms.
• Interest may provide a tax shield.
• Creditors' returns are less volatile than shareholders' returns.

Moderate debt usage can therefore lower WACC. Excessive debt, however, may cause:

• Credit rating downgrades
• Higher corporate bond yields and bank borrowing rates
• Greater bankruptcy and refinancing risk
• Higher interest expense
• Greater residual risk for shareholders
• Higher beta and cost of equity
• Greater risk of covenant breaches

WACC does not fall indefinitely as debt weight rises. Beyond a certain point, both debt and equity costs can increase, pushing WACC higher again.

3-7. Assess ROIC and WACC together

ROIC is the return actually earned from operations, while WACC is the return required by capital providers.

\[ ROIC\ Spread = ROIC-WACC \]

A simple economic profit calculation is:

\[ \text{Economic profit} = NOPAT-(\text{Average invested capital}\times WACC) \]

Alternatively:

\[ \text{Economic profit} = (ROIC-WACC)\times \text{Average invested capital} \]

A positive ROIC spread does not automatically make a good investment. Shares may be overvalued if the market already fully prices in the sustainability of high ROIC.

3-8. WACC connects to enterprise value through DCF

FCFF, the free cash flow available to the entire firm, is generally discounted at WACC.

\[ \text{Enterprise value} = \sum_{t=1}^{n} \frac{FCFF_t}{(1+WACC)^t} + \frac{Terminal\ Value}{(1+WACC)^n} \]

A higher WACC discount rate reduces the present value of future cash flows.

\[ WACC\uparrow \Rightarrow \text{Present value}\downarrow \]

Conversely, all else equal, a lower WACC increases present value.

\[ WACC\downarrow \Rightarrow \text{Present value}\uparrow \]

Growth companies whose cash flows are concentrated far in the future are especially sensitive to discount-rate changes. This is one reason high-growth share prices can fluctuate sharply when interest rates rise.

3-9. Do not apply company-wide WACC to every business

WACC generally reflects average business risk and capital structure across the company. Applying one WACC to divisions or projects with different risks can distort investment decisions.

For example, valuing both an established, stable telecommunications network and an uncertain new-technology investment at 8% can overstate the riskier technology project's value.

• Established, stable business → A relatively low discount rate may be appropriate
• New, high-risk business → A relatively high discount rate is needed
• Business in another country → Reflect country risk and currency
• Startup or early-stage business → Consider failure risk separately

In actual company analysis, apply discount rates appropriate to each business unit's risk, country, currency, and capital structure.

4. A simple numerical example

The following are nonfinancial company A's hypothetical figures for this lesson. Amounts are in KRW hundred million, and all market data is assumed to be from the same valuation date.

① Capital structure

\[ \text{Equity weight} = 1,200\div2,000 = 60\% \]

\[ \text{Debt weight} = 800\div2,000 = 40\% \]

② Cost of equity

Assume the following:

• Risk-free rate: 4%
• Beta: 1.2
• Market risk premium: 6%

\[ R_e = 4\%+1.2\times6\% = 11.2\% \]

③ After-tax cost of debt

Assume the following:

• Pre-tax cost of debt: 6%
• Normalized corporate tax rate: 25%

\[ \text{After-tax cost of debt} = 6\%\times(1-25\%) = 4.5\% \]

④ Calculate WACC

\[ WACC = 60\%\times11.2\% + 40\%\times4.5\% \]

\[ WACC = 6.72\%+1.80\% = 8.52\% \]

In this hypothetical calculation, company A's WACC is approximately 8.5%. The company as a whole must therefore generate long-term capital returns of approximately 8.5% or more to meet capital providers' required returns.

⑤ ROIC spread and economic profit

Assume company A has 13% ROIC and average invested capital of KRW 1,500 hundred million.

\[ ROIC\ Spread = 13\%-8.52\% = 4.48\%p \]

\[ \text{Economic profit} = 4.48\%\times1,500 = 67.2\text{ hundred million KRW} \]

In this hypothetical calculation, A generates approximately KRW 67.2 hundred million in annual economic profit after covering its cost of capital.

⑥ How changes in WACC affect value

For simplicity, assume A generates KRW 100 hundred million of FCFF annually from next year, with no growth forever.

The value of a perpetual cash flow growing at 0% is:

\[ \text{Enterprise value} = \frac{FCFF}{WACC} \]

At a WACC of 8.52%:

\[ \text{Enterprise value} = 100\div8.52\% \approx1,174\text{ hundred million KRW} \]

If higher market rates and risk premiums raise WACC to 9.52%:

\[ \text{Enterprise value} = 100\div9.52\% \approx1,050\text{ hundred million KRW} \]

Cash flow is unchanged, but a 1-percentage-point increase in WACC reduces this simple enterprise value by approximately KRW 124 hundred million, or 10.6%.

This is an extremely simplified hypothetical teaching example. A real DCF must reflect period-specific FCFF, growth rates, net debt, non-operating assets, and multiple scenarios.

5. Practical use in stock and company analysis

① Compare ROIC and WACC on consistent terms

ROIC measures the return on shareholder and creditor capital invested in the core business. Its benchmark should therefore be WACC, combining both groups' required returns.

• ROIC ↔ WACC
• ROE ↔ Cost of equity
• FCFF ↔ WACC
• FCFE, free cash flow to equity ↔ Cost of equity

Valuation is distorted if the numerator and discount rate apply to different capital providers.

For example, discounting FCFF, which is before interest expense, at the cost of equity can substantially undervalue the firm.

② Do not treat WACC as one precise number

Most WACC inputs are estimates.

• Beta measurement period
• Benchmark index
• Risk-free rate maturity
• Market risk premium
• Normalized tax rate
• Target capital structure
• Current borrowing rates
• Country risk premium

In practice, a range is therefore safer than a single WACC.

For example:

• Optimistic scenario: 7.5%
• Base scenario: 8.5%
• Conservative scenario: 9.5%

Also review DCF results in a sensitivity table combining discount rates and long-term growth rates.

③ Understand how higher market rates transmit through WACC

Higher market interest rates can generally raise WACC through the following channels:

\[ \text{Government bond yields rise}\rightarrow\text{Risk-free rate rises}\rightarrow\text{Cost of equity rises} \]

\[ \text{Market rates rise}\rightarrow\text{New borrowing rates rise}\rightarrow\text{Cost of debt rises} \]

\[ \text{WACC rises}\rightarrow\text{Present value of future cash flows falls} \]

However, interest rates alone do not determine share prices. Enterprise value can rise if revenue, margin, and FCF prospects improve more than the adverse effect of rising rates.

Separate these two effects:

• Discount-rate effect: Higher WACC is negative for value
• Cash-flow effect: Improving economic conditions, pricing, and demand may support value

④ Do not assume more debt is positive

Adding debt because it costs less than equity may initially reduce WACC. Excessive debt, however, increases these risks:

• Weaker interest coverage
• Credit rating downgrades
• Higher refinancing rates
• Concentrated maturity risk
• Possible equity issuance
• Reduced investment during downturns
• Less capacity for dividends and buybacks

Alongside WACC, therefore, examine:

\[ \text{Net debt}/EBITDA \]

\[ \text{Interest coverage ratio} = \frac{\text{Operating profit or } EBITDA}{\text{Interest expense}} \]

\[ FCF/\text{Net debt} \]

A low calculated WACC due to high debt weight may be misleading if debt and equity costs do not adequately reflect increased financial risk.

⑤ Future ROIC and WACC matter more than historical ROIC

Company value depends on future cash flows and risks, not past results.

Be cautious with the following companies despite high historical ROIC:

• Companies facing price declines from intensifying competition
• Companies with falling utilization after major capacity expansion
• Companies with sharply rising new-product development costs and CapEx
• Companies facing higher refinancing costs as market rates rise
• Companies facing greater regulatory or country risk
• Companies attracting new competitors through high profitability

Conversely, a company with low current ROIC may be revalued if restructuring, normalized pricing, new plant operations, or improved product mix could push future ROIC above WACC.

⑥ Assess how much of a high ROIC spread is priced in

A company with 25% ROIC and 8% WACC is not automatically a buy. The market may assign a very high valuation in expectation that this competitive advantage will persist for years.

Link three questions in actual investing:

1. What is the current ROIC spread?
2. How long can that spread persist?
3. How much growth and persistence does the current share price already reflect?

Rather than high ROIC alone, the ability to reinvest at higher returns for longer than the market expects may be the key to excess returns.

⑦ Be careful when directly comparing WACC across industries

Stable consumer-staples companies, regulated infrastructure businesses, early-stage biotech firms, and cyclical semiconductor companies have different business risks.

A lower-WACC company is not necessarily better. Lower WACC generally indicates lower risk; what matters is how high its ROIC is relative to that risk.

\[ \text{Key assessment} = \text{ROIC level}-\text{WACC level} \]

Also calculate ROIC and WACC using the same currency, date, and consistent capital-structure assumptions.

6. What to look for in filings

Disclosures alone cannot provide a complete WACC. Some inputs come from financial statements and notes, and others must be obtained from market data as of the valuation date.

Korean companies: What to check on DART

The Financial Supervisory Service's DART annual, half-year, and quarterly reports should be reviewed for the following consolidated figures.

Goodwill or cash-generating-unit impairment notes sometimes disclose discount rates. These may be pre-tax rates for particular businesses or rates specifically for impairment testing, so do not assume they equal company-wide WACC.

US companies: What to check in 10-K and 10-Q filings

SEC EDGAR for the following information.

• Consolidated Balance Sheets
• Short-term debt
• Long-term debt
• Interest expense
• Income Taxes
• Leases
• Fair Value of Financial Instruments
• Liquidity and Capital Resources
• Contractual Obligations
• Commitments and Contingencies
• Stockholders’ Equity
• Earnings per Share

In a 10-K, financial statements are mainly in Item 8. Financial Statements and Supplementary Data and in a 10-Q, in Part I, Item 1. Financial Statements, together with the notes.

For recent bond issuance, also check interest rates, maturities, and amounts in 8-K filings, prospectuses, or related securities offering documents.

Market data to obtain separately from disclosures

The following information generally does not appear in complete form in financial statements:

When documenting WACC, record at least the following:

• Valuation date
• Valuation currency
• Risk-free rate and maturity
• Beta source and measurement period
• Market risk premium
• Basis for the cost of debt
• Applicable tax rate
• Scope of debt included
• Equity and debt weights
• Base, optimistic, and conservative scenarios

Distinguish disclosed facts from analyst estimates as follows:

• R(Reported): Figures directly reported in filings
• M(Market): Market observations on the valuation date
• C(Calculated): Values calculated from filings and market data
• E(Estimated): Analyst assumptions or estimates

7. Key takeaways

• WACC is the cost of capital obtained by weighting shareholder and creditor required returns according to capital structure.
• The basic formula is Equity weight × Cost of equity + Debt weight × After-tax cost of debt.
• The cost of equity is generally estimated as Risk-free rate + Beta × Market risk premium using this relationship.
• The after-tax cost of debt is generally calculated as Pre-tax cost of debt × (1 − Tax rate), but verify that the tax shield is actually usable.
• Capital-structure weights should generally use market rather than book values.
• Moderate debt can lower WACC, but excessive debt can increase both debt and equity costs.
• ROIC above WACC suggests potential economic value creation; below WACC, even growth may destroy value.
• FCFF is generally discounted at WACC; a higher WACC reduces the present value of future cash flows.
• WACC is an estimated range rather than one exact number, so discount-rate sensitivity analysis is necessary.
• Do not apply company-wide WACC uniformly to all divisions and projects with different risks.
• Obtain debt, interest-rate, and tax-rate information from filings, and separately obtain share prices, government bond yields, beta, and market risk premiums as of the same valuation date.

8. 3 review questions

Question 1

A company has a risk-free rate of 3.5%, beta of 1.1, and a market risk premium of 6%. Calculate its cost of equity using CAPM.

Question 2

The following are hypothetical figures for company B:

• Market value of equity: KRW 700 hundred million
• Interest-bearing debt: KRW 300 hundred million
• Cost of equity: 12%
• Pre-tax cost of debt: 5%
• Normalized tax rate: 20%

Calculate company B's WACC.

Question 3

Both companies have 11% ROIC.

• Company C: WACC of 7%, with stable ROIC over many years
• Company D: WACC of 12%, with ROIC rising temporarily only during economic booms

Which company currently appears to create economic value more reliably, and what else should you check before buying its shares?

Answers and explanations

Answer 1

\[ R_e = 3.5\%+1.1\times6\% \]

\[ R_e = 3.5\%+6.6\% = 10.1\% \]

The CAPM-estimated cost of equity is 10.1%.

Answer 2

First calculate the capital-structure weights.

\[ \text{Equity weight} = 700\div(700+300) = 70\% \]

\[ \text{Debt weight} = 300\div1,000 = 30\% \]

The after-tax cost of debt is:

\[ \text{After-tax cost of debt} = 5\%\times(1-20\%) = 4\% \]

WACC is therefore:

\[ WACC = 70\%\times12\% + 30\%\times4\% \]

\[ WACC = 8.4\%+1.2\% = 9.6\% \]

Company B's hypothetical WACC is 9.6%.

Answer 3

Company C's ROIC spread is:

\[ 11\%-7\%=4\%p \]

Company D's ROIC spread is:

\[ 11\%-12\%=-1\%p \]

Based solely on the information given, company C creates economic value more reliably. Its ROIC exceeds WACC by 4 percentage points and has been stable over many years.

D may fail to meet capital providers' required returns despite reporting operating profit. If its current ROIC is temporarily elevated by a boom, normalized ROIC could be even lower.

Before buying C's shares, however, also check:

• Whether competitive advantages can sustain high ROIC
• Whether growth and reinvestment opportunities are sufficient
• Whether WACC assumptions are appropriate
• Whether the share price already overstates high ROIC and growth
• Whether valuation is reasonable relative to normalized FCF

Next lesson — Day 10:
“Turning future cash flows into today's value — The basics of DCF and enterprise valuation”