Weighted Average Cost of Capital
- What does Weighted Average Cost of Capital (WACC) mean?
- The weighted average cost of capital or WACC is the rate a company expects to pay on average to finance its assets. Company’s primary sources of financing include two things; debt and equity. WACC is the average cost of raising that money.
Simplified WACC Formula
The simplified formula uses the metric v (total value of capital) = e (equity) + d (debt). Also, percentages are abstracted to keep things simple.
WACC = `(e/v * re) + ((d/v * rd) * (1 - tc))`
Extended WACC Formula
The extended formula is the exact formula you can use on the inputs to calculate WACC. It is more verbose than the simplified formula.
WACC = `100 * (e / (e + d) * ((re) / 100) + d / (e + d) * ((rd) / 100) * (1 - (tc) / 100))`
- re = cost of equity
- e = total equity
- rd = cost of debt
- d = total debt
- tc = corporate tax rate
Let’s consider a firm's financial data:
- Equity (e) = $10000
- Debt (d) = $100
- Cost of Equity (re) = 10%
- Cost of Debt (Re) = 10%
- Tax Rate (tc) = 5%
Applying, the formula:-
- `100 * (e / (e + d) * ((re) / 100) + d / (e + d) * ((rd) / 100) * (1 - (tc) / 100))`
- `100 * (10000 / (10000 + 100) * (10 / 100) + 100 / (10000 + 100) * (10 / 100) * (1 - 5 / 100))`
- `100 * (10000 / 10100 * 0.1 + 100 / 10100 * 0.1 * (1 - 0.05))`
- `100 * (0.9901 * 0.1 + 0.0099 * 0.1 * 0.95)`
- `100 * (0.099 + 0.001 * 0.95)`
- `100 * (0.099 + 0.0009)`
- `100 * 0.1`
- WACC = `9.995%`
- Importance of WACC
One of the primary goal of an entrepreneur is to increase the valuation of his/her company. Any business needs some base capital to get started. For example, to setup a factory you need money to buy land & construct the factory. You can even purchase an existing factory. Then, you must hire people to work in the factory, buy raw materials, etc.
Capital can be divided into two, equity and debt. Equity is the total value of all assets owned by the company. While debt is the money the company borrowed. Bonds, common stocks & preferred stocks all fall into these two categories.
The capital that a company gains comes at a price, though. The company might have taken a loan from the bank for the initial funding. This loan must be paid back to the bank with an interest. All equity comes with such a cost of debt. The amount you repay will always have an interest rate factored into it.
Cost of equity is considered to be the expense that the company incurred in order to get the equity. Shareholders, take a risk by investing in the company's stocks. The required rate of return for their investment is one such factor that goes into this cost of equity.
Most companies are financed by both Equity and Debt. The WACC metric combines these into a single figure - Weighted Average Cost of Capital. It is the average rate that the company must pay across all it's security holders to finance its assets. The WACC figure can be compared with the company's Rate of Return (ROI) to judge whether the company is profitable.
On the other hand, investors use it to decide whether it is worthwhile to make an investment in a company. The general rule of thumb is to NOT invest in a company if the WACC is lesser than or only slightly greater than the ROI.
- Oct 25, 2018
- Calculation formula breakdown and table
- May 16, 2018
- Tool Launched