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Weighted Average
Cost of Capital
(WACC) Guide
Home » Financial Ratio Analysis » Weighted Average Cost of Capital (WACC) Guide

What is WACC?
Definition: The weighted average cost of capital (WACC) is a financial
ratio that calculates a company’s cost of financing and acquiring assets by
comparing the debt and equity structure of the business. In other words, it
measures the weight of debt and the true cost of borrowing money or
raising funds through equity to finance new capital purchases and
expansions based on the company’s current level of debt and equity
structure.
Management typically uses this ratio to decide whether the company
should use debt or equity to finance new purchases.

This ratio is very comprehensive because it averages all sources of capital;

including long-term debt, common stock, preferred stock, and bonds; to
measure an average cost of borrowing funds. It is also extremely complex.
Figuring out the cost of debt is pretty simple. Bonds and long-term debt are
issued with stated interest rates that can be used to compute their overall
cost. Equity, like common and preferred shares, on the other hand, does
not have a readily available stated price on it. Instead, we must compute an
equity price before we apply it to the equation.

That’s why many investors and creditors tend not to focus on this
measurement as the only capital price indicator. Estimating the cost of
equity is based on several different assumptions that can vary between
investors. Let’s take a look at how to calculate WACC.
What is the WACC Formula?
The WACC formula is calculated by dividing the market value of the firm’s
equity by the total market value of the company’s equity and debt multiplied
by the cost of equity multiplied by the market value of the company’s debt
by the total market value of the company’s equity and debt multiplied by the
cost of debt times 1 minus the corporate income tax rate.

Wow, that was a mouthful. Here’s what the equation looks like.

Here’s a list of the elements in the weighted average formula and what
each mean.

 Re = total cost of equity

 Rd = total cost of debt
 E = market value total equity
 D = market value of total debt
 V = total market value of the company’s combined debt and equity or
E+D
 E/V = equity portion of total financing
 D/V = debt portion of total financing
 Tc = income tax rate

WACC Calculation
Now let’s break the WACC equation down into its elements and explain it in
simpler terms.

The WACC calculation is pretty complex because there are so many

different pieces involved, but there are really only two elements that are
confusing: establishing the cost of equity and the cost of debt. After you
have these two numbers figured out calculating WACC is a breeze.

Cost of Equity
The cost of equity, represented by Re in the equation, is hard to measure
precisely because issuing stock is free to company. A company doesn’t pay
interest on outstanding shares. In addition, each share of stock doesn’t
have a specified value or price. It simply issues them to investors for
whatever investors are willing to pay for them at any given time. When the
market it high, stock prices are high. When the market is low, stock prices
are low. There’s no real stable number to use. So how to measure the cost
of equity?

We need to look at how investors buy stocks. They purchase stocks with
the expectation of a return on their investment based on the level of risk.
This expectation establishes the required rate of return that the company
must pay its investors or the investors will most likely sell their shares and
invest in another company. If too many investors sell their shares, the stock
price could fall and decrease the value of the company. I told you this was
somewhat confusing. Think of it this way. The cost of equity is the amount
of money a company must spend to meet investors’ required rate of return
and keep the stock price steady.

Cost of Debt
Compared with the cost of equity, the cost of debt, represented by Rd in
the equation, is fairly simple to calculate. We simply use the market interest
rate or the actual interest rate that the company is currently paying on its
obligations. Keep in mind, that interest expenses have additional tax
implications. Interest is typically deductible, so we also take into account
the amount of tax savings the company will be able to take advantage of by
making its interest payments, represented in our equation Rd(1 – Tc)

So what does all this mean?

What is WACC Used For?

To put it simply, the weighted average cost of capital formula helps
management evaluate whether the company should finance the purchase
of new assets with debt or equity by comparing the cost of both options.
Financing new purchases with debt or equity can make a big impact on the
profitability of a company and the overall stock price. Management must
use the equation to balance the stock price, investors’ return expectations,
and the total cost of purchasing the assets. Executives and the board of
directors use weighted average to judge whether a merger is appropriate or
not.

Investors and creditors, on the other hand, use WACC to evaluate whether
the company is worth investing in or loaning money to. Since the WACC
represents the average cost of borrowing money across all financing
structures, higher weighted average percentages mean the company’s
overall cost of financing is greater and the company will have less free cash
to distribute to its shareholders or pay off additional debt. As the weighted
average cost of capital increases, the company is less likely to create value
and investors and creditors tend to look for other opportunities.

WACC Analysis
You can think of this as a risk measurement. As the average cost
increases, the company must equally increase its earnings and ability to
pay the higher costs or investors won’t see a return and creditors won’t be
repaid. Investors use a WACC calculator to compute the minimum
acceptable rate of return. If their return falls below the average cost, they
are either losing money or incurring opportunity costs.
Let’s take a look at an example.

WACC Example
Assume the company yields an average return of 15% and has an average
cost of 5% each year. The company essentially makes a 10% return on
every dollar it invests in itself. An investor would view this as the company
generating 10 cents of value for every dollar invested. This 10-cent value
can be distributed to shareholders or used to pay off debt.

Now let’s look at an opposite example. Assume that the company only
makes a 10% return at the end of the year and has an average cost of
capital of 15 percent. This means the company is losing 5 cents on every
dollar it invests because its costs are higher than its returns. No investor
would be attracted to a company like this. Its management should work to
restructure the financing and decrease the company’s overall costs.
As you can see, using a weighted average cost of capital calculator is not
easy or precise. There are many different assumptions that need to take
place in order to establish the cost of equity. That’s why many investors
and market analysts tend to come up with different WACC numbers for the
same company. It all depends on what their estimations and assumptions
were. This is why many investors use this ratio for speculation purposes
and tend to value more concrete calculations for serious investing
decisions.

Here is a calculator for you to work out your own examples with.