July 17, 2019
Using ‘Weighted Average Cost of Capital’ to Test Performance Targets
– Liz Dunshee
Here’s a suggestion from this Pay Governance memo by John Ellerman:
The weighted average cost of capital (WACC) is an important financial precept that is widely used in financial circles to test whether a return on investment can exceed or meet an asset, project, or company’s cost of invested capital (equity + debt). The thesis of this opinion article is that companies can develop more meaningful return performance targets by better understanding the details of its WACC before setting a return performance target.
Simply stated, a company’s return on capital performance target will be more relevant if in fact the return shows that the level of performance to be achieved must equal or exceed the company’s estimated cost of capital. Directors serving on the Board’s compensation committee can use the WACC model to test the validity and reasonableness of an incentive plan’s return performance target by learning whether the return target meets or exceeds the company’s WACC over the performance period.