Weighted average cost of capital

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 the minimum return that a company must earn on existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure and is used to see if the investment is worthwhile to undertake.

The more complex the company's capital structure, the more laborious it is to calculate the WACC.

General formula

In general, the WACC can be calculated with the formula:

${\text{WACC}}=\sum _{i=1}^{N}\left(r_{i}\cdot {\frac {MV_{i}}{\sum _{j=1}^{N}MV_{j}}}\right)$, where $N$ is the number sources of capital (securities, types of liabilities); $r_{i}$ is the required rate of return for security $i$; $MV_{i}$ is the market value of all outstanding securities $i$.

The formula for a simple case

In a simple case where the company is financed by homogeneous equity and debt, the weighted average cost of capital can be found through:

${\text{WACC}}=\left({E \over {D+E}}\right)\cdot y+\left({D \over {D+E}}\right)\cdot d\left(1-t_{C}\right)$, where $\ y=t_{R}+t_{P}\cdot B$, where:

Symbol	Meaning	Units
$\ y\$	required or expected rate of return on equity, or cost of equity	%
$\ d$	required or expected rate of return on borrowings before taxes	%
$\ t_{R}$	risk free rate	%
$\ t_{P}$	risk premium rate	%
$\ B$	Beta coefficient	-
$\ t_{C}$	corporate tax rate	%
$\ D$	total debt and leases (including current portion of long-term debt and notes payable)	currency
$\ E$	total market value of equity and equity equivalents or market cap (number of shares outstanding X share price)	currency
$\ K$	total capital invested in the going concern	currency

Example

Capital Component	Cost	x	% of capital structure	Total
Retained Earnings	8%	X	30%	2.4%
Common Stocks	9%	X	10%	0.9%
Preferred Stocks	10%	X	15%	1.5%
Debt (Bonds)	6.67%	X	45%	3.0%
TOTAL			100%	7.8%

The WACC of this company is 7.8%

See also

• Beta coefficient
• Cost of capital
• Discounted cash flow
• Economic Value Added
• Internal rate of return
• Minimum acceptable rate of return
• Modigliani-Miller theorem
• Net present value
• Opportunity cost

External links

• Video about practical application of the WACC approach
• Yee, Kenton K., "Earnings Quality and the Equity Risk Premium: A Benchmark Model" . Contemporary Accounting Research, Vol. 23, No. 3, pp. 833-877, Fall 2006. Available at SSRN: http://ssrn.com/abstract=921914.
• Velez-Pareja, Ignacio and Tham, Joseph, "A Note on the Weighted Average Cost of Capital WACC" (August 7, 2005). Available at SSRN: http://ssrn.com/abstract=254587. Unpublished.
• Cheremushkin, Sergei Vasilievich, How to Avoid Mistakes in Valuation - Comment to 'Consistency in Valuation: A Practical Guide' by Velez-Pareja and Burbano-Perez and Some Pedagogical Notes on Valuation and Costs of Capital (December 21, 2009). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1526681. Unpublished.
• WACC calculator Microsoft Excel spreadsheet
• A more realistic valuation: APV and WACC with constant book leverage ratio
• calculate the firm's Weighted Average Cost of Capital to publicly traded stock (only with the ticker symbol)
• calculate the WACC with your own values to understand the equation
• Find the WACC of any publicly traded company by entering the firm's stock ticker symbol
• Paper describing a method for generating the WACC curve when there is default risk - spreadsheet available