Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is a financial metric that represents a firm’s average cost of capital from all sources, including debt and equity, weighted according to the proportion of each source in the capital structure.

Definition of WACC

WACC provides an organization with a measure of its cost of financing and is crucial for investment decisions, project evaluation, and valuation processes. It serves as the discount rate for cash flows in discounted cash flow (DCF) analysis.

Components of WACC

The WACC formula accounts for the cost of equity, cost of debt, and the corresponding weights of equity and debt within a company’s capital structure. Each component is broken down as follows:

Cost of Equity

The cost of equity represents the return a company must offer to its equity investors to compensate them for the risk of investing in the business. It can be estimated using models such as the Capital Asset Pricing Model (CAPM).

Cost of Debt

The cost of debt is the effective rate that a company pays on its borrowed funds. This is usually calculated as the yield to maturity on existing debt or the current market rate for new debt, adjusted for the tax deductibility of interest payments.

Weights of Debt and Equity

The weights in the WACC formula are derived from the market value of equity (market capitalization) and the market value of debt, which reflects the proportion of total capital that each component represents.

WACC Calculation

The formula for calculating WACC is as follows:

• WACC = (E/V * Re) + (D/V * Rd * (1 – Tc))

Where:

• E = Market value of equity
• D = Market value of debt
• V = Total market value of the firm (E + D)
• Re = Cost of equity
• Rd = Cost of debt
• Tc = Corporate tax rate

Real-World Example of WACC

Consider a company with the following information:

• Market value of equity (E) = $800,000
• Market value of debt (D) = $200,000
• Cost of equity (Re) = 10%
• Cost of debt (Rd) = 5%
• Corporate tax rate (Tc) = 30%

First, calculate the total market value (V):

• V = E + D = $800,000 + $200,000 = $1,000,000

Next, use the WACC formula:

• WACC = (800,000 / 1,000,000 * 0.10) + (200,000 / 1,000,000 * 0.05 * (1 – 0.30))
• WACC = (0.8 * 0.10) + (0.2 * 0.05 * 0.7)
• WACC = 0.08 + 0.007
• WACC = 0.087 or 8.7%

In this example, the company’s weighted average cost of capital is 8.7%, indicating the average rate of return it must earn to satisfy its investors.