Weighted Average Cost of Capital (WACC)Definition, Formula, and How to Calculate

A business, small or large, can be funded either through debt, equity, or a mix of both.

Corporations in particular are typically funded by common stocks.

Some have other kinds of equity instruments as well as debt instruments (e.g. bonds).

That’s not to say that sole proprietorships and partnerships cannot be funded by debt and/or equity.

They can, just not in the form of stocks.

The thing about corporations though is that ownership can be easily transferred.

Whoever owns a stock, even if it’s just 1 unit of stock, owns a part of the corporation.

What’s more, once a corporation’s stock becomes available to the public, anyone can become an owner of the corporation.

Just like any owner, stockholders purchase stocks expecting that they’ll get a return.

This return is typically in the form of dividends.

A stockholder can also get his/her return by selling his/her stock at a higher rate than what s/he paid for.

On the corporation’s part, the dividends that it distributes to its shareholders is a cost of acquiring capital through equity (e.g. stocks).

A corporation can also acquire funding through debt (e.g. loans, bonds, debentures).

Creditors typically don’t become owners of the corporation.

That means that the corporation’s relationship with them ends once the debt is fully paid.

Much like stockholders, creditors extend funding to corporations expecting that they’ll get a return.

This return is typically in the form of interest. Unlike dividends that are only distributed when a corporation declares it, interest is paid whether the corporation likes it or not.

This makes interest a cost of acquiring capital through debt.

Whether it’s debt or equity, capital has a cost (unless it’s donated capital).

As a business owner, you would want to know your business’s cost of capital.

Weighted Average Cost of Capital (WACC) – what is it?

The weighted average cost of capital or WACC is a financial ratio that represents the average cost of capital from all sources.

This includes capital from equity (e.g. common stocks, preferred stocks) and debt (e.g. bonds, loans).

It takes into account how much each of the fund sources contributes to the total capital of the business.

Whether it’s debt or equity, capital has a cost (unless it’s donated capital). Stockholders (equity) expect dividends on their investments.

Creditors (debt) expect interest on top of principal repayments.

Finding the balance between the fund sources is essential in determining the business’s optimal WACC.

The more optimized WACC is, the higher the potential profits will be.

A business’s management can use WACC to evualte whether additional funds should be sourced from debt or equity.

By comparing the cost of both options, management can assess which source of funding is more economical.

WACC can also be used as a figure to determine the minimum rate of return required to avoid incurring a loss.

If a business’s WACC is 8%, then its rate of return must be more than 8% for it to generate a profit.

From an investor’s point of view, WACC is one of the many factors in deciding whether it’s worth it to invest in the business or not.

WACC can be used to assess the riskiness of an investment.

A high WACC might mean that the investment is volatile and very risky.

On the other hand, a low WACC usually signifies that the investment is stable.

WACC can also be used in discounted cash flow (DCF) analysis.

It can be used as the rate for calculating the present value of a future cash flow.

The WACC formula

WACC can be calculated using the following formula:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = the market value of a business’s equity

D = the market value of a business’s debt

V = total value of capital (E + D)

Re = cost of equity

Rd = cost of debt

T = tax rate

The formula can be split into two parts. One part is the weighted average cost of equity.

It is represented by the first part of the equation which is E/V x Re.

The other part is the weighted average cost of debt. It is represented by the latter part of the equation which is D/V x Rd x (1 – T).

If a business’s capital structure consists of 100% equity, then WACC will be equal to the cost of equity.

If it consists of 100% debt, then WACC will be equal to the cost of debt.

The formula may look intimidating at first because of the many variables, but if you’re familiar with them, it is quite simple.

It’s just adding the weighted average cost of equity and debt to arrive at the WACC figure.

That said, while the formula is simple, acquiring the figures for the variables isn’t.

The data gathering process becomes more complicated the more complex a business’s capital structure is.

Another caveat of the WACC formula is that it is computed with the following assumptions:

• There would be no future changes in the capital structure
• There would be no future changes in the risk profile

The components of the WACC formula

The WACC formula essentially has 6 components:

• Market value of a business’s equity (E)
• Market value of a business’s debt (D)
• Total value of capital (V)
• Cost of equity (Re)
• Cost of debt (Rd)
• Tax rate (T)

Of the six components, the tax rate is probably the easiest to gather.

You just need to refer to the prevailing tax rate that governs the business.

The market value of both equity and debt could take some time but isn’t too complicated.

The market value of debt of equity and debt instruments can be found in public listings.

For other debts such as loans, the book value might suffice.

Once you have both the market value of equity and debt, you can add them up to get the total value of capital.

Determining the cost of debt may take some time if a business has many debt sources.

Nonetheless, it is a fairly straightforward process. You only need to calculate the average yield to maturity of all outstanding debts. The resulting figure is your cost of debt (Rd).

The cost of equity (Re) is probably the hardest to gather.

The intrinsic value of a stock is affected by many factors.

You can base it on its market price.

You can also because it on the dividends that it historically received.

Because of this, it’s hard to put an explicit value on share capital.

As a result, the cost of equity is oftentimes an estimated figure.

Calculating WACC

To deepen our understanding of the WACC formula, let’s have a quick exercise:

Company A has the following capital structure:

Share Capital
Book Value	$2,500,000.00
Market Value	$3,000,000.00
Outstanding Debt	$2,000,000.00

Upon research, the following figures were gathered:

Cost of Equity	9%
Cost of Debt	12%
Tax Rate	35%

Assuming that the market value of debt is equal to the book value, let us compute for company A’s WACC.

First, we must get the value for (V) which is the total value of capital:

V = E + D

= $3,000,000 + $2,000,000

= $5,000,000

Now that we have our value for (V), we can proceed with the computation of WACC:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

= ($3,000,000 / $5,000,000 x 9%) + (($2,000,000 / $5,000,000 x 12%) x (1 – .035))

= (0.60 x 9% =) + ((0.40 x 12%) x (0.65))

= 5.4% + (4.8% x 0.65)

= 5.4% + 3.12%

= 8.52%

As per computation, company A’s WACC is 8.52%. This means that $100 of capital costs company A $8.52.

As such, company A must have a rate of return greater than 8.52% so that it can generate a profit.

Take note that this is only a simple example.

In actual practice, the computation of WACC can get complicated real quick due to the complexity of capital structures.

Limitations of WACC

The most obvious limitation of WACC is that some of its components, particularly the cost of equity, aren’t consistent.

The equation is simple, yes. But gathering the data required for the computation of WACC isn’t.

Aside from that, there are many ways to calculate the formula, particularly its variables.

For example, the book values of equity and debt can be used instead of market value.

There are many ways in determining the cost of equity such as the CAPM model.

Because of this, the computation of WACC greatly varies from business to business.

As such, while it is a useful tool, it doesn’t have a high level of comparability.

It may be better to rely on other metrics when comparing with other businesses.

Another limitation of WACC is that it assumes a certain capital structure.

This means that it assumes that the capital structure used in the computation will not change in the future.

In actual practice, this is not the case. A business may decide to repay all debts, issue more stocks, or recall a portion of outstanding stocks.

All of these actions affect a business’s capital structure.