Weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds, and any other long-term debt. In other words, WACC is the rate a company expects to pay on average to finance its assets. Since a company has two primary sources of financing – debt and equity – WACC is the average cost of raising that money.
Formula for WACC
WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the WACC value:
WACC = x Re + x Rd x (1 – Tc)
- Re = cost of equity
- Rd = cost of debt
- E = market value of the firm’s equity
- D = market value of the firm’s debt
- V = E + D
- E/V = percentage of financing that is equity
- D/V = percentage of financing that is debt
- Tc = corporate tax rate
The Components of WACC
As stated above, a company finances its assets either through debt or with equity. WACC is the average of the costs of these types of financing, each of which is weighted by its proportionate use in a given situation.
Cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership.
Cost of debt refers to the effective rate a company pays on its current debt. In most cases, this refers to the after-tax cost of debt, but it also means the company's cost of debt before taking taxes into account. The difference in cost of debt before and after taxes lies in the fact that interest expenses are deductible.
To calculate WACC, you'll need to determine how much of the company is financed by equity and how much by debt. Once you have what proportions of the firm's total financing that is comprised of debt and equity, you multiply each by its respective cost as shown below:
Steps in Calculating WACC
When calculating a firm's WACC, the first step is to determine what proportion of a firm is financed by equity and what proportion is financed by debt.
This is done by entering the appropriate values into the and components of the equation. Next, the proportion of equity () is multiplied by the cost of equity (Re), and the proportion of debt () is multiplied by the cost of debt (Rd).
The debt side of the equation (* Rd) is then multiplied by (1 - Tc) to get the after-tax cost of debt (there is a tax shield associated with interest). The final step is to add the equity side of the equation to the debt side of the equation to determine WACC.
For example, a firm's financial data shows the following:
- Equity = $8,000
- Debt = $2,000
- Re = 12.5%
- Rd = 6%
- Tax rate = 30%
To find WACC, enter the values into the equation and solve:
WACC =[( x 0.125)] + [( * 0.06 * (1 - 0.3)]
WACC = 0.1 + .0084 = 0.1084 or 10.84%; the WACC for this firm then is 10.84%.
The Bottom Line
WACC is used by security analysts and investors when assessing the value of investments and when determining which ones to pursue. Investors may often use WACC as an indicator of whether or not an investment is worth pursuing. Put simply, WACC is the minimum acceptable rate of return at which a company yields returns for its investors. To see how the Federal Reserve and Treasuries impact WACC, please read "How Do Interest Rates Affect The WACC Calculation?"
To determine an investor’s returns on an investment in a company, simply subtract the WACC from the company’s returns percentage. For example, suppose that a company yields returns of 20% and has a WACC of 11%. This means the company is yielding 9% returns on every dollar the company invests. In other words, for each dollar spent, the company is creating nine cents of value. On the other hand, if the company's return is less than WACC, the company is losing value. If a company has returns of 11% and a WACC of 17%, the company is losing six cents for every dollar spent, indicating that potential investors would be best off putting their money elsewhere.
WACC can serve as a useful reality check for investors; however, the average investor would rarely go to the trouble of calculating WACC because it is a complicated measure that requires a lot of detailed company information. Since the calculation is so involved, most investors use online analysis tools to find a company's WACC. Nonetheless, being able to calculate WACC can help investors understand WACC and its significance when they see it in brokerage analysts' reports. As a result, understanding WACC can help investors make more informed investment decisions.