Human capital represents the combined value of skills, knowledge, and abilities held by a company’s employees. It is an intangible asset capable of bolstering a company’s productivity, innovation, and competitiveness. Nevertheless, human capital often goes unnoticed or undervalued in the traditional computation of the weighted average cost of capital (WACC).
WACC, the average rate a company pays to finance its assets, is typically derived by assigning weights to the cost of each capital source—such as debt and equity—based on their proportions in the company’s capital structure. While the cost of debt pertains to the interest rate on borrowings, the cost of equity signifies the anticipated return demanded by shareholders for their investments. A lower WACC implies greater company value, suggesting the company can generate returns surpassing its capital costs.
This conventional approach, however, fails to consider the cost and value associated with human capital, which can substantially impact a company’s economic value added (EVA). EVA measures the excess profit a company earns over its cost of capital and is calculated as the net operating profit after taxes (NOPAT) minus the product of invested capital and WACC. A higher EVA signifies greater value creation for shareholders.
Human capital influences both NOPAT and invested capital. On one hand, it can boost NOPAT by enhancing operational efficiency, quality, and innovation. On the other hand, it may increase invested capital by necessitating additional investments in employee training, development, and retention.
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As a result, the effect of human capital on EVA can be positive or negative, depending on whether the benefits outweigh the costs. Strategic investment in human capital can enhance EVA by increasing NOPAT more than invested capital. Conversely, neglecting or mismanaging human capital can reduce EVA by increasing invested capital more than NOPAT.
Some researchers propose incorporating human capital into WACC calculation by adding a human capital component to the formula. This component is estimated by multiplying the human capital value (HCV) by the human capital cost (HCC). HCV is measured by the present value of future earnings of employees, while HCC is measured by the expected return employees require for working in the company. This inclusion enables a more accurate reflection of the true cost and value of human capital.
Kenyan firms are urged to adopt this strategy to determine the optimal cost of capital. This approach can facilitate informed investment decisions, align incentives with employees, and enhance competitive advantage. By integrating human capital into WACC, Kenyan firms can more accurately evaluate project profitability and feasibility, accounting for the impact of human capital on cash flows and risks. Furthermore, by linking WACC to HCC, firms can motivate employees and differentiate themselves from competitors, leveraging unique and valuable human resources to create superior value for customers and shareholders.
