What Is the Weighted Average Cost of Capital (WACC)?
The weighted average cost of capital (WACC) represents a firm's average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. WACCis the average rate a company expects to pay to finance its assets.
The weighted average cost of capital is a common way to determine required rate of return because it expresses, in a single number, the return that both bondholders and shareholders demand in order to provide the company with capital. A firm’s WACC is likely to be higher if its stock is relatively volatile or if its debt is seen as risky because investors will require greater returns.
- WACC represents a firm's cost of capital where each category of capital is proportionately weighted.
- WACC is commonly used as a hurdle rate against which companies and investors can gauge the desirability of a given project or acquisition.
- 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.
- WACC is also used as the discount rate for future cash flows in discounted cash flow analysis.
Weighted Average Cost Of Capital (WACC)
WACC and its formula are useful for analysts, investors, and company management—all of whom use it for different purposes. In corporate finance, determining a company’s cost of capital is vital for a couple of reasons. For instance, WACC is the discount rate that a company uses to estimate its net present value.
WACC is also important when analyzing the potential benefits of taking on projects or acquiring another business. If the company believes that a merger, for instance, will generate a return higher than its cost of capital, it’s likely a good choice for the company. If its management anticipates a return lower than what their own investors are expecting, they’ll want to put their capital to better use.
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. Weighted average cost of capital measures a company’s cost to borrow money. The WACC formula uses both the company’s debt and equity in its calculation.
In most cases, a lower WACC indicates a healthy business that’s able to attract investors at a lower cost. By contrast, a higher WACC usually coincides with businesses that are seen as riskier and need to compensate investors with higher returns.
If a company only obtains financing through one source—say, common stock—calculating its cost of capital would be relatively simple. If investors expected a rate of return of 10% in order to purchase shares, the firm’s cost of capital would be the same as its cost of equity: 10%.
The same would be true if the company only used debt financing. For example, if the company paid an average yield of 5% on its outstanding bonds, its cost of debt would be 5%. This is also its cost of capital.
Many companies generate capital from a combination of debt and equity (such as stock) financing. To express the cost of capital in a single figure, one has to weigh its cost of debt and cost of equity proportionally, based on how much financing is acquired through each source.
WACC Formula and Calculation
WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight and then adding the products together. In the above formula, E/V represents the proportion of equity-based financing, while D/V represents the proportion of debt-based financing. The WACC formula thus involves the summation of two terms:
The former represents the weighted value of equity capital, while the latter represents the weighted value of debt capital.
Suppose that a company obtained $1,000,000 in debt financing and $4,000,000 in equity financing by selling common shares. E/V would equal 0.8 ($4,000,000 ÷ $5,000,000 of total capital) and D/V would equal 0.2 ($1,000,000 ÷ $5,000,000 of total capital).
Calculating WACC in Excel
The weighted average cost of capital can be calculated in Excel. The biggest challenge is sourcing the correct data to plug into the model. See Investopedia’s notes on how to calculate WACC in Excel.
Explaining the Formula Elements
Cost of equity (Re) can be a bit tricky to calculate because share capital does not technically have an explicit value. When companies reimburse bondholders, the amount they pay has a predetermined interest rate. On the other hand, equity has no concrete price that the company must pay. As a result, companies have to estimate cost of equity—in other words, the rate of return that investors demand based on the expected volatility of the stock.
Because shareholders will expect to receive a certain return on their investments in a company, the equity holders' required rate of return is a cost from the company's perspective; if the company fails to deliver this expected return, shareholders will simply sell off their shares, which leads to a decrease in share price and in the company’s value. The cost of equity, then, is essentially the total return that a company must generate in order to maintain a share price that will satisfy its investors.
Companies typically use the Capital Asset Pricing Model (CAPM) to arrive at the cost of equity (in CAPM, it’s called the expected return of investment). Again, this is not an exact calculation because firms have to lean on historical data, which can never accurately predict future growth.
Determining the cost of debt (Rd), on the other hand, is a more straightforward process. This is often done by averaging the yield to maturity for a company’s outstanding debt. This method is easier if you’re looking at a publicly traded company that has to report its debt obligations.
For privately owned companies, one can look at the company’s credit rating from firms such as Moody’s and S&P and then add a relevant spread over risk-free assets (for example, Treasury notes of the same maturity) to approximate the return investors would demand.
Businesses are able to deduct interest expenses from their taxes. Because of this, the net cost of a company's debt is the amount of interest it is paying minus the amount it has saved in taxes. This is why Rd (1 - the corporate tax rate) is used to calculate the after-tax cost of debt.
Who Uses WACC?
Securities analysts may use WACC when assessing the value of investment opportunities. For example, in discounted cash flow analysis, one may apply WACC as the discount rate for future cash flows in order to derive a business's net present value.
WACC may be used internally by the finance team as a hurdle rate for pursuing a given project or acquisition. If the company’s investment in a new manufacturing facility, for example, has a lower rate of return than its WACC, the company will probably hold back and find other uses for that money.
WACC vs. Required Rate of Return (RRR)
The required rate of return (RRR) is the minimum rate an investor will accept for a project or investment. If they expect a smaller return than what they require, they’ll allocate their money elsewhere.
One way to determine the RRR is by using the CAPM, which uses a stock’s volatility relative to the broader market (its beta) to estimate the return that stockholders will require.
Another method for identifying the RRR is by calculating the WACC. The advantage of using WACC is that it takes the company’s capital structure into account—that is, how much it leans on debt financing versus equity.
Limitations of WACC
The WACC formula seems easier to calculate than it really is. Because certain elements of the formula, such as the cost of equity, are not consistent values, various parties may report them differently for different reasons. As such, although WACC can often help lend valuable insight into a company, one should always use it along with other metrics when determining whether to invest in a company.
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.
In addition, 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.
Example of How to Use WACC
As an example, consider a hypothetical manufacturer called XYZ Brands. Suppose the book value and market value of the company’s debt are $1,000,000, and its market capitalization (or the market value of its equity) is $4,000,000.
Let’s further assume that XYZ’s cost of equity—the minimum return that shareholders demand—is 10%. Here, E/V would equal 0.8 ($4,000,000 of equity value divided by $5,000,000 of total financing). Therefore, the weighted cost of equity would be .08 (0.8 x .10). This is the first half of the WACC equation.
Now we have to figure out XYZ’s weighted cost of debt. To do this, we need to determine D/V; in this case, that’s 0.2 ($1,000,000 in debt, divided by $5,000,000 in total capital). Next, we would multiply that figure by the company’s cost of debt, which we’ll say is 5%. Last, we multiply the product of those two numbers by 1 minus the tax rate. So if the tax rate is 0.25, “1 minus Tc” is equal to 0.75.
In the end, we arrive at a weighted cost of debt of .0075 (0.2 x .05 x 0.75). When that’s added to the weighted cost of equity (.08), we get a WACC of .0875, or 8.75% (0.08 weighted cost of equity + 0.0075 weighted cost of debt).
That represents XYZ’s average cost to attract investors and the return that they’re going to expect, given the company’s financial strength and risk compared with other opportunities.
What Is Weighted Average Cost of Capital (WACC)?
The weighted average cost of capital represents the average cost to attract investors, whether they're bondholders or stockholders. The calculation weights the cost of capital based on how much debt and equity the company uses, which provides a clear hurdle rate for internal projects or potential acquisitions.
Who Uses Weighted Average Cost of Capital?
WACC is used in financial modeling (it serves as the discount rate for calculating the net present value of a business). It’s also the “hurdle rate” that companies use when analyzing new projects or acquisition targets. If the company’s allocation can be expected to produce a return higher than its own cost of capital, then it’s typically a good use of funds.
Are WACC and Required Rate of Return (RRR) the Same?
The weighted average cost of capital is one way to arrive at the required rate of return—that is, the minimum return that investors demand from a particular company. A key advantage of WACC is that it takes the company’s capital structure into consideration. If a company primarily uses debt financing, for instance, its WACC will be closer to its cost of debt than its cost of equity.
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by the external market and not by management.Why WACC is calculated? ›
The purpose of WACC is to determine the cost of each part of the company's capital structure based on the proportion of equity, debt, and preferred stock it has. Each component has a cost to the company. The company pays a fixed rate of interest on its debt and a fixed yield on its preferred stock.What are the the components of the WACC weighted average cost of capital )? ›
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 ...How do you calculate WACC example? ›
Unlike measuring the costs of capital, the WACC takes the weighted average for each source of capital for which a company is liable. You can calculate WACC by applying the formula: WACC = [(E/V) x Re] + [(D/V) x Rd x (1 - Tc)], where: E = equity market value.How do you calculate weighted average cost? ›
To calculate the weighted average cost, divide the total cost of goods purchased by the number of units available for sale. To find the cost of goods available for sale, you'll need the total amount of beginning inventory and recent purchases.How do you calculate WACC without debt? ›
If a company has no long term debt - the WACC of a company will be its cost of equity - or the capital asset pricing model. This is because the WACC equation is the cost of debt * percent of debt in the capital structure * (1 - tax rate) + cost of equity * percent of equity in the capital structure.Is cost of capital and WACC the same? ›
What is the difference between Cost of Capital and WACC? Cost of capital is the total of cost of debt and cost of equity, whereas WACC is the weighted average of these costs derived as a proportion of debt and equity held in the firm.How do you calculate WACC for a private company? ›
The WACC for a Private Company is calculated by multiplying the cost of each source of funding – either equity or debt – by its respective weight (%) in the capital structure.When calculating WACC what capital is excluded and why? ›
What Capital Is Excluded When Calculating WACC? When using WACC to calculate the cost of debt focuses on the two sources of financing: equity financing and debt financing. Accounts payable and accruals are not considered in the WACC formula.What does a WACC of 6% mean? ›
Example of a High Weighted Average Cost of Capital (WACC)
Because shareholders expect a return of 6% on their investment, the cost of equity is 6%. XYZ then sells 4,000 bonds for $1,000 each to raise the other $4,000,000 in capital. The people who bought those bonds expect a 5% return, so XYZ's cost of debt is 5%.
The weighted average cost of capital (WACC) is the average cost of the entity's finance (equity, bonds, bank loans, and preference shares) weighted according to the proportion each element bears to the total pool of funds.Where do I find WACC? ›
How do I find the weighted average cost of capital (WACC)?
- Open Excel on one of the terminals in the library.
- Click on the S&P Capital IQ tab.
- Download the +WACC template by navigating to Templates\Valuation\+WACC.
- Select the +WACC template to display it on the screen.
WACC is expressed as a percentage, like interest. So for example if a company works with a WACC of 12%, than this means that only (and all) investments should be made that give a return higher than the WACC of 12%.How is cost of capital calculated? ›
- Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)
- Equity is the amount of cash available to shareholders as a result of asset liquidation and paying off outstanding debts, and it's crucial to a company's long-term success.
WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight by market value, then adding the products together to determine the total. WACC is also used as the discount rate for future cash flows in discounted cash flow analysis.What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt 20% on its equity and has a 40% tax rate? ›
WACC = (50% x 20%) + (50% x 12% x 60%) WACC = 0.1 + 0.036. WACC = 0.136 or 13.60%What is a good WACC for a company? ›
As a rule of thumb, a good WACC is one that is in line with the sector average. When investors and lenders require a higher rate of return to finance a company it may indicate that they consider it riskier than the sector.When calculating the weighted average cost of capital weights are based on quizlet? ›
Terms in this set (30) When calculating the weighted average cost of capital, weights are based on: Market values.Why is WACC used as discount rate? ›
Answer and Explanation: The WACC means the cost of capital of an organization and this portrays the rate of return the investors require. The WACC is used as a discount rate when the organization wants to generate as much cash flows as it is paying to the investors for their capital.How many ways are there to calculate WACC? ›
4 Innovative Methods To Calculate WACC (Resourceful) | eduCBA.
The discount rate is an investor's desired rate of return, generally considered to be the investor's opportunity cost of capital. The Weighted Average Cost of Capital (WACC) represents the average cost of financing a company debt and equity, weighted to its respective use.What is similar to WACC? ›
One alternative, called adjusted present value (APV), is especially versatile and reliable, and will replace WACC as the DCF methodology of choice among generalists.Is CAPM used to calculate WACC? ›
The CAPM is a formula for calculating cost of equity. The cost of equity is part of the equation used for calculating the WACC. The WACC is the firm's cost of capital which includes the cost of the cost of equity and cost of debt.Which is better CAPM or WACC? ›
Using the CAPM will lead to better investment decisions than using the WACC in the two shaded areas, which can be represented by projects A and B. Project A would be rejected if WACC is used as the discount rate, because the internal rate of return (IRR) of the project is less than the WACC.What is weighted average cost of capital WACC )? Why do we need WACC for computing Eva? ›
WACC: An Investment Tool
It also plays a key role in economic value added (EVA) calculations. Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Let's say a company produces a return of 20% and has a WACC of 11%.
In essence the WACC is a percentage and is (in the context of valuating a startup) a way to define the risk an investor is taking when he/she invests in a firm. The higher the WACC percentage, the higher the risk and the lower the valuation of your firm.Can you use CAPM for private companies? ›
Calculating Beta for Private Firms
The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM). The cost of debt will often be determined by examining the target's credit history to determine the interest rates being charged to the firm.
Three main types of valuation methods are commonly used for establishing the economic value of businesses: market, cost, and income; each method has advantages and drawbacks.What are excluded in WACC? ›
WACC only includes capital sources that come from investors. Therefore, it includes all loans, notes and mortgages, retained earnings and equity contributions you and investors make. It excludes liabilities that are not debt. Accounts payable, accrued liabilities and deferred revenues are all excluded.What happens to WACC if debt increases? ›
While increasing debt in the beginning “averages down” the company's WACC, taking on too much debt will cause the cost of debt and equity beta to increase dramatically, reflecting the increased financial risk of the business. At that point, WACC starts to rise and that decreases Enterprise Value.
The firm's overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.What if WACC is less than growth? ›
In the above calculation, if we assume WACC < growth rate, then the value derived from the formula will be Negative. This is very difficult to digest as a high-growth company is now showing a negative terminal value because of the formula used.How do you calculate WACC debt? ›
Notice in the Weighted Average Cost of Capital (WACC) formula above that the cost of debt is adjusted lower to reflect the company's tax rate. For example, a company with a 10% cost of debt and a 25% tax rate has a cost of debt of 10% x (1-0.25) = 7.5% after the tax adjustment.
The weighted cost of capital (WACC) measures a firm's cost of capital, e.g. what it costs to finance firm assets. WACC consists of the weighted average of the various types of capital a firm can use to finance its operations—debt, preferred stock, retained earnings, and external equity.How does net working capital affect the NPV of a 5 year project if working capital is expected to increase by $25000 and the firm has a 15% cost of capital? ›
How does net working capital affect the NPV of a 5-year project if working capital is expected to increase by $25,000 and the firm has a 15% cost of capital? Therefore NPV is decreased by the difference of $12,570.58.Which capital structure should provide the lowest weighted average cost of capital? ›
In theory, debt financing offers the lowest cost of capital due to its tax deductibility.What is WACC used for? ›
The weighted average cost of capital (WACC) is an important financial precept that is widely used in financial circles to test whether a return on investment can exceed or meet an asset, project, or company's cost of invested capital (equity + debt).How do you calculate cost of capital on a balance sheet? ›
- Re = cost of equity (expected rate of return on equity)
- Rd = cost of debt (expected rate of return on debt)
- E = market value of company equity.
- D = market value of company debt.
- V = total capital invested, which equals E + D.
- E/V = percentage of financing that is equity.
- 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.
Answer and Explanation: Weighted Average Cost of Capital (WACC) is expressed in a percentage form like interest rate. If a company works with a 12% WACC, all investments should give a higher return than the 12% of WACC.
To calculate the weighted average cost, divide the total cost of goods purchased by the number of units available for sale. To find the cost of goods available for sale, you'll need the total amount of beginning inventory and recent purchases.How is weighted average calculated? ›
To find a weighted average, multiply each number by its weight, then add the results. If the weights don't add up to one, find the sum of all the variables multiplied by their weight, then divide by the sum of the weights.How do you calculate cost of capital for a project? ›
Find the difference between the market rate of return and the risk-free rate of return. Multiply the difference by beta, which measures market volatility. Add this product to the risk-free interest rate. The sum is your cost of equity.What is cost of capital Example? ›
The firm's overall cost of capital is based on the weighted average of these costs. For example, consider an enterprise with a capital structure consisting of 70% equity and 30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.Which statement best describes the weighted average cost of capital? ›
WACC is an average of these costs of capital on the basis of weights of respective source in the capital of company. Thus, WACC is can be best described as "the cost of capital of a firm that finances with both debt and equity" from above statements.What is the difference between IRR and WACC? ›
IRR & WACC
The primary difference between WACC and IRR is that where WACC is the expected average future costs of funds (from both debt and equity sources), IRR is an investment analysis technique used by companies to decide if a project should be undertaken.
WACC = (50% x 20%) + (50% x 12% x 60%) WACC = 0.1 + 0.036. WACC = 0.136 or 13.60%Is cost of capital and WACC the same? ›
What is the difference between Cost of Capital and WACC? Cost of capital is the total of cost of debt and cost of equity, whereas WACC is the weighted average of these costs derived as a proportion of debt and equity held in the firm.What is the formula for calculating cost of capital? ›
- Cost of Debt = (Risk-Free Rate of Return + Credit Spread) × (1 – Tax Rate)
- Equity is the amount of cash available to shareholders as a result of asset liquidation and paying off outstanding debts, and it's crucial to a company's long-term success.
The cost of capital is based on the weighted average of the cost of debt and the cost of equity. In this formula: E = the market value of the firm's equity. D = the market value of the firm's debt.
As a rule of thumb, a good WACC is one that is in line with the sector average. When investors and lenders require a higher rate of return to finance a company it may indicate that they consider it riskier than the sector.When calculating WACC what capital is excluded and why? ›
What Capital Is Excluded When Calculating WACC? When using WACC to calculate the cost of debt focuses on the two sources of financing: equity financing and debt financing. Accounts payable and accruals are not considered in the WACC formula.How do you calculate WACC for a private company? ›
The WACC for a Private Company is calculated by multiplying the cost of each source of funding – either equity or debt – by its respective weight (%) in the capital structure.What can I use instead of WACC? ›
Today's better alternative, adjusted present value (APV), is especially versatile and reliable. It will likely replace WACC as the DCF methodology of choice among generalists. Like WACC, APV is used to value operations, or assets-in-place-that is, any existing asset that will generate a stream of future cash flows.Is WACC used to calculate IRR? ›
When to Use WACC and IRR. The WACC is used in consideration with IRR but is not necessarily an internal performance return metric, that is where the IRR comes in. Companies want the IRR of any internal analysis to be greater than the WACC in order to cover the financing.Is the WACC the same as the discount rate? ›
Your company's weighted average cost of capital (WACC, a discount rate formula we'll show you how to calculate shortly) is often used as the discount rate when calculating NPV, although it is sometimes thought to be more appropriate to use a higher discount rate to adjust for risk or opportunity cost.What is the weighted average cost of capital for a firm with 40 debt? ›
Answer and Explanation: The calculated value of the weighted average cost of capital (WACC) is option C. 12%.How do you calculate WACC without debt? ›
If a company has no long term debt - the WACC of a company will be its cost of equity - or the capital asset pricing model. This is because the WACC equation is the cost of debt * percent of debt in the capital structure * (1 - tax rate) + cost of equity * percent of equity in the capital structure.When calculating the weighted average cost of capital WACC an adjustment is made for taxes because? ›
The correct answer was C) 5.3%. Q8: When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes because: B. Equity and preferred stock are not adjusted for taxes because dividends are not deductible for corporate taxes.