How to calculate weighted average cost of capital (WACC)?
The weighted average cost of capital (WACC) is considered the “blended” cost of capital across all different types of debt and equity. The cost of each type of capital is weighted by its percentage of total capital and then is added together to get the overall weighted average cost of capital. The visual below illustrates how WACC at a high-level is the combination of the average cost of equity and the average cost of debt:
What is the formula for WACC?
Below is the formula for calculating weighted average cost of capital (WACC). Does it surprise you that the WACC formula is quite whacky? No, but here it is for you:
If you are great with formulas, then the formula for WACC above will get the job done. However, let’s go ahead and break down the process of calculating the WACC into four simple repeatable steps with our mental map below:
Step 1) Capital Structure: The first step will always be to figure out the company’s capital structure using the market value for debt and equity. This means that you have to understand the ratio of debt to total capital and the ratio of equity to total capital. The ratio for debt and equity should equal 100% when added together.
Step 2) WACC for Equity: Next, you will figure out the weighted average cost of equity by multiplying the cost of equity by the ratio or % of equity. You will typically be given the cost of equity, but you will also need to know the different ways to calculate the cost of equity. If the company has several different types of equity like common and preferred stock, you will have to perform separate calculations for the cost of common equity and the cost of preferred stock.
Step 3) WACC for Debt: The process to calculate the weighted average cost of debt starts by multiplying the cost of debt (typically based on the annual interest rate) by the ratio of debt. We also have to factor in the tax rate since interest expense can be used as a tax deduction. After finding the pre-tax WACC for debt, multiply by “1 minus the tax rate)” to get the WACC for debt on a post-tax basis.
Step 4) Combine the WACC’s – Once you have calculated the WACC for each component of equity and each type of debt, you simply add the rates together to get the overall (“blended”) weighted average cost of capital for the company.
Example WACC Calculation
Step 1) The first step is to calculate the ratio between debt and equity. The question tells us that the capital structure for Jazz Music Store is 25% common equity and debt of 75%. This means that the company has chosen to use debt to finance their growth more so than equity.
Step 2) We now need to calculate the WACC for equity. The question tells us that the cost of common equity is 10%. Multiply the cost of common equity of 10% by the equity ratio of 25%, and that means the WACC for equity is 2.50%. (Click here to learn the methods of calculating the cost of common equity).
Step 3) We need to perform a similar calculation for debt, except we must factor in the tax rate. Start by multiplying the cost of debt of 5% by the ratio of debt of 75%, and that equals 3.75%. To factor in the tax rate, multiply by 1 minus the tax rate of 20%. Take 3.75% x 80%, and that means the WACC for debt is 3.00%.
Step 4) Now we just add the WACC for equity of 2.50% from step #2 and the WACC for debt (post-tax) of 3.00% from step #3, and that means the combined WACC for Jazz Music is 5.50%.
How to interpret the WACC?
Now that we know the components and how to calculate the WACC for a company, how do we interpret the WACC and use it to make business decisions? The WACC simply tells us the return that both equity and debt holders expect to receive. A company needs to have an attractive WACC and a plan to increase the WACC to raise money from investors and/or lenders.
Overall, the WACC can be used by a company to determine whether or not they should invest in a project or business. The company must be able to generate a return in excess of the WACC, otherwise, the company will lose (“shed”) value. The WACC is often used as the discount rate in for net present value calculations or a discounted cash flow analysis. The WACC is also used as the hurdle rate for evaluating opportunities like acquisitions or investments.
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