Weighted average cost of capital (WACC) is used by analysts and investors to assess an investor’s returns on an investment in a company. As the majority of businesses run on borrowed funds, the cost of capital becomes an important parameter in assessing a firm’s potential for net profitability. WACC measures a company’s cost to borrow money, where the WACC formula uses both the company’s debt and equity in its calculation.
- The weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted.
- All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.
- WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight by market value, and then adding the products together to determine the total.
- The cost of equity can be found using the capital asset pricing model (CAPM).
- WACC is used by investors to determine whether an investment is worthwhile, while company management tends to use WACC when determining whether a project is worth pursuing.
Weighted Average Cost Of Capital (WACC)
What Is the Weighted Average Cost of Capital (WACC)?
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 average rate a company expects to pay to finance its assets.
Companies often run their business using the capital they raise through various sources. They include raising money through listing their shares on the stock exchange (equity), or by issuing interest-paying bonds or taking commercial loans (debt). All such capital comes at a cost, and the cost associated with each type varies for each source.
Since a company’s financing is largely classified into two types—debt and equity—WACC is the average cost of raising that money, which is calculated in proportion to each of the sources.
Why the WACC Formula Is Important
WACC is a formula that gives insight into how much interest a company owes for each dollar it finances. Analysts use WACC to assess the value of an investment. WACC is a key number used in discounted cash flow (DCF) analysis. Company management also uses WACC figures as a hurdle rate when choosing which projects to undertake. Meanwhile, investors will use WACC when assessing whether an investment is viable.
The Formula for WACC
The WACC formula includes the weighted average cost of equity plus the weighted average cost of debt. Note that, generally, the cost of debt is lower than the cost of equity given that interest expenses are tax-deductible.
WACC=(VE×Re)+(VD×Rd×(1−Tc))where:E=Market value of the firm’s equityD=Market value of the firm’s debtV=E+DRe=Cost of equityRd=Cost of debtTc=Corporate tax rate
How to Calculate WACC
WACC formula is the summation of two terms:
The former represents the weighted value of equity-linked capital, while the latter represents the weighted value of debt-linked capital.
The calculation of the WACC generally uses the market value of the various components versus book value—because the expected cost of new capital is more important than the sale of existing assets for WACC purposes.
Equity and Debt Components of WACC Formula
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 value. In the above formula, E/V represents the proportion of equity-based financing, while D/V represents the proportion of debt-based financing.
It’s a common misconception that equity capital has no concrete cost that the company must pay after it has listed its shares on the exchange. In reality, there is a cost of equity. The shareholders’ expected rate of return is considered a cost from the company’s perspective.
That’s because if the company fails to deliver this expected return, shareholders will simply sell off their shares, which will lead to a decrease in share price and the company’s overall valuation. The cost of equity is essentially the amount that a company must spend in order to maintain a share price that will keep its investors satisfied and invested.
One can use the CAPM (capital asset pricing model) to determine the cost of equity. CAPM is a model that established the relationship between the risk and expected return for assets and is widely followed for the pricing of risky securities like equity, generating expected returns for assets given the associated risk, and calculating costs of capital.
The CAPM requires the risk-free rate, beta, and historical market return—note that the equity risk premium (ERP) is the difference between the historical market return and the risk-free rate.
Generally, the lower the WACC the better. A lower WACC represents lower risk for a company’s operations.
The debt portion of the WACC formula represents the cost of capital for company-issued debt. It accounts for interest a company pays on the issued bonds or commercial loans taken from the bank.
Example of How to Use WACC
Let’s calculate the WACC for retail giant Walmart (WMT). In April 2021, the risk-free rate as represented by the annual return on a 20-year treasury bond was 2.21%. Walmart’s beta was 0.48 as of April 14, 2021. Meanwhile, the average long-term return of the market is roughly 8%. Using the CAPM, Walmart’s cost of equity is 4.99%.
The market cap for Walmart was $394 billion as of April 14, 2021. The long term debt stood at $44 billion as of the end of fiscal year 2021 and its average cost of debt was 3.9%.
The WACC for Walmart is as follows:
V = E + D = $394 billion + $44 billion = $438 billion
The equity-linked cost of capital for Walmart is:
(E/V) x Re = (394 / 438) x 4.99% = 0.045
The debt component is:
(D/V) x Rd x (1 – Tc) = (44 / 438) x 3.9% x (1 – 33.3%) = 0.0026
Using the above two computed figures, WACC for Walmart can be calculated as:
0.045 + 0.0026 = 4.76%
On average, Walmart is paying around 4.76% per year as the cost of overall capital raised via a combination of debt and equity.
The above example is a simple illustration to calculate WACC. One may need to compute it in a more elaborate manner if the company is having multiple forms of capital with each having a different cost.
For instance, if the preferred shares are trading at a different price than common shares, if the company issued bonds of varying maturity are offering different returns, or if the company has a commercial loan at different interest rates, then each such component needs to be accounted for separately and added together in proportion of the capital raised.
There are online calculators that can be used to calculate WACC.
Limitations of WACC
The WACC can be difficult to calculate if you’re not familiar with all the inputs. Higher debt levels mean the investor or company will require higher WACCs. More complex balance sheets, such as varying types of debt with various interest rates, make it more difficult to calculate WACC. There are many inputs to calculating WACC—such as interest rates and tax rates—all of which can be affected by market and economic conditions.
Together, the debt and equity mix of a company are considered its capital structure. One downside to the WACC is that it assumes a set capital structure. That is, the WACC assumes that the current capital structure will remain the same in the future.
Another limitation of WACC is the fact that there are various ways of calculating the formula, which can leave to different results. The WACC is also not suitable for accessing risky projects because to reflect the higher risk the cost of capital will be higher. Instead, investors may opt to use the adjusted present value (APV), which does not use the WACC.
What Is the WACC Formula?
The WACC formula is calculated as (E/V * Re) + [D/V * Rd * (1 – Tc)].
How Do I Calculate WACC?
WACC is calculated with the following variables: E is the firm’s equity market value, D is the firm’s debt market value, Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate.
What Is a Good WACC?
A “good” WACC is usually a lower WACC. A high WACC is generally a signal of higher risk. All else equal, the lower the WACC the higher the market value of the company.
What Is the WACC Used For?
WACC is used as a benchmark on whether to invest in a project or company. It’s an internal calculation to determine a company’s cost of capital.
Is WACC Nominal or Real?
WACC is based on nominal rates, and thus, most WACC calculations are considered nominal. The inputs for the WACC calculation are nominal, such as the cost of debt, bond cash flows, stock prices, and free cash flows.
The Bottom Line
WACC is a formula that takes into account a company’s cost debt and equity using a formula, although it can also be calculated using excel. The formula is useful analysts, investors, and company management—all of whom use it for different purposes.
View more information: https://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp