Weighted average cost of capital (WACC) formula

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The weighted average cost of capital (WACC) is used by analysts and investors to assess an investor’s return on an investment in a company. As the majority of businesses operate with borrowed funds, the cost of capital becomes an important parameter in assessing the potential for net profitability of a business. The WACC measures the cost of borrowing a business, where the WACC formula uses both debt and equity of the business in its calculation.

Key points to remember

  • The Weighted Average Cost of Capital (WACC) is a calculation of a company’s cost of capital in which each category of capital is weighted proportionately.
  • All sources of capital, including common stocks, preferred stocks, bonds, and other long-term debt, are included in a WACC calculation.
  • The WACC is calculated by multiplying the cost of each source of capital (debt and equity) by its relevant weight by the market value, and then adding the products together to determine the total.
  • The cost of equity can be found using the capital asset valuation model (CAPM).
  • WACC is used by investors to determine whether an investment is worth pursuing, while company management tends to use WACC to determine 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 sources of capital, including common stocks, preferred stocks, bonds, and other long-term debt. In other words, WACC is the average rate a business expects to pay to finance its assets.

Companies often run their businesses using the capital they raise from a variety of sources. These include raising funds by listing their shares on the stock exchange (stocks), or by issuing bonds at interest or taking out commercial loans (debt). All of this capital has a cost, and the cost associated with each type varies for each source.

Since the financing of a business is largely classified into two typesdebt and equityThe WACC is the average cost of collecting this money, which is calculated in proportion to each of the sources.

Why the WACC Formula is Important

WACC is a formula that gives an overview of how much interest a business owes for every dollar it funds. Analysts use the 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 cut-off rate when deciding which projects to undertake. During this time, investors will use the WACC to assess whether an investment is viable.

The WACC formula

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, since interest charges are tax deductible.













WACC


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D


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or:
















E


=


Market value of the company’s equity
















D


=


Company debt market value
















V


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E


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D
















R


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Cost of equity
















R


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The cost of debt
















T


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Corporate tax rate







begin {aligned} & text {WACC} = left ( frac {E} {V} times Re right) + left ( frac {D} {V} times Rd times (1 – Tc ) right) & textbf {where:} & E ​​= text {Market value of company equity} & D = text {Market value of company debt} & V = E + D & Re = text {Cost of equity} & Rd = text {Cost of debt} & Tc = text {Corporate tax rate} end { aligned}



WACC=(VE×Re)+(VD×RD×(1Tvs))or:E=Market value of the company’s equityD=Company debt market valueV=E+DRe=Cost of equityRD=The cost of debtTvs=Corporate tax rate

How to calculate the WACC

The WACC formula is the sum of two terms:



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E


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left ( frac {E} {V} times Re right)



(VE×Re)



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D


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R


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left ( frac {D} {V} times Rd times (1 – Tc) right)



(VD×RD×(1Tvs))

The first represents the weighted value of equity related capital, while the second represents the weighted value of debt related capital.

The WACC calculation typically uses the market value of the various components relative to the book value, as the expected cost of new capital is greater than the sale of existing assets for WACC purposes.

Equity and debt components of the WACC formula

The WACC is calculated by multiplying the cost of each source of capital (debt and equity) by its relevant weight, then adding the products 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 is a common misconception that equity does not have a tangible cost that a company has to pay after going public. In reality, there is a cost of equity capital. The expected rate of return from shareholders is viewed as a cost from a business perspective.

This is because if the company fails to deliver this expected return, the shareholders will simply sell their shares, which will cause the share price and the overall valuation of the company to fall. The cost of equity is basically the amount a company must spend to maintain a stock price that will satisfy and invest its investors.

The CAPM (capital asset pricing model) can be used to determine the cost of equity. CAPM is a model that established the relationship between risk and expected return on assets and is widely followed for pricing risky securities like stocks, 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.

In general, the lower the WACC, the better. A lower WACC represents a lower risk to a company’s operations.

The debt portion of the WACC formula represents the cost of capital for debt issued by the business. It records the interest that a company pays on bonds issued or commercial loans taken out with the bank.

Example of using WACC

Let’s calculate the WACC for retail giant Walmart (WMT). In April 2021, the risk-free rate represented by the annual yield on a 20-year Treasury bill was 2.21%. Walmart’s beta was 0.48 as of April 14, 2021. Meanwhile, the long-term average market return is around 8%. Using the CAPM, Walmart’s cost of equity is 4.99%.

Walmart’s market capitalization was $ 394 billion as of April 14, 2021. Long-term debt stood at $ 44 billion at the end of fiscal 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 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 two numbers calculated above, the WACC for Walmart can be calculated as follows:

0.045 + 0.0026 = 4.76%

On average, Walmart pays around 4.76% per year as the overall cost of capital raised through a combination of debt and equity.

The above example is a simple illustration to calculate WACC. It may be necessary to calculate it more elaborately if the business has more than one form of capital, each with a different cost.

For example, if preferred stocks trade at a different price than common stocks, if the company has issued bonds of varying maturity that offer different yields, or if the company has a business loan at different interest rates. , then each of these elements must be accounted for separately and added in proportion to the capital raised.

There are online calculators that can be used to calculate the WACC.

Limitations of WACC

The WACC can be difficult to calculate if you are not familiar with all of the inputs. Higher debt levels mean that the investor or business will need higher WACCs. More complex balance sheets, such as different types of debt with different interest rates, make it more difficult to calculate the WACC. There are many inputs to calculate WACC, such as interest rates and tax rates, all of which can be affected by market and economic conditions.

Together, the composition of a company’s debt and equity is considered its capital structure. A downside of WACC is that it assumes a fixed 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 different ways to calculate the formula, which can lead to different results. WACC is also not suitable for accessing risky projects because to reflect the higher risk the cost of capital will be higher. Instead, investors can choose to use Adjusted Present Value (APV), which does not use WACC.

WACC FAQ

What is the WACC formula?

The WACC formula is calculated as (E / V * Re) + [D/V * Rd * (1 – Tc)].

How to calculate the WACC?

The WACC is calculated with the following variables: E is the market value of the company’s equity, D is the market value of the company’s debt, 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 usually a sign of higher risk. All other things being equal, the lower the WACC, the higher the market value of the business.

What is the WACC for?

The WACC is used as a benchmark for whether to invest in a project or a business. It is an internal calculation to determine the cost of capital of a business.

Is WACC nominal or real?

WACC is based on nominal rates and therefore most WACC calculations are considered nominal. The inputs for calculating the WACC are nominal, such as cost of debt, bond cash flow, stock prices, and free cash flow.

The bottom line

WACC is a formula that takes into account a company’s cost of debt and equity using a formula, although it can also be calculated using Excel. The formula is useful for analysts, investors, and company management, all of whom use it for different purposes.


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