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 an 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:

${\text{WACC}}={\frac {\sum _{i=1}^{N}r_{i}\cdot MV_{i}}{\sum _{i=1}^{N}MV_{i}}}$

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 $i$.

Formula

Usually, WACC is calculated using the equity and debt a company has, using the formula:

WACC = E/(D+E)*Re + D/(D+E)*Rd*(1-t)

E = amount of equity the company has D = amount of debt the company has Re = cost of equity Rd = cost of debt t = corporate tax rate

This WACC formula demonstrates the benefit a company receives from issuing debt because interest paid on debt is tax deductible. According to pure Corporate Finance theory, a company should try to finance its operations with as large a proportion of debt as possible. However, this does not actually happen in real life for a variety of reasons. For one, as a company has a higher amount of debt in its corporate structure, we can expect the company to have to pay higher and higher interest rates on that debt because of the increased risk to a lender providing financing to the company.

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 online WACC calculator
• 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