What is Weighted Average Cost of Capital (WACC)?
The Weighted Average Cost of Capital (WACC) is an average of the costs of the different types of financing a company uses to generate returns for investors –– taking into account the relative weight of each factor.
🤔 Understanding WACC
WACC tells you what it costs a company to generate returns for its investors. It is useful because it tells you the minimum rate of return to target for your investment in a company. A company’s capital structure contains debt (things like loans and bonds) and equity (things like common and preferred stock). Companies use this capital to purchase assets (things like factories, data centers, and office buildings) and generate profit for owners and investors. If the rate of return a company produces is less than its WACC, then the company is losing value for investors. If it generates higher returns than its WACC, then it is creating value for investors above its cost of capital. For this reason, WACC is a useful tool to use when evaluating different investment opportunities.
Let’s assume you have some cash to invest and are evaluating two different opportunities. Company A has a rate of return of 8%, and Company B is generating a 7% return. If you only look at the rate of return, then Company A appears to be a better investment. But how much does it cost Company A and B to produce those returns? That’s where WACC comes in.
Now let’s assume Company A’s WACC is 8%, while Company B’s is 4%. When you take the WACC into account, Company A is generating 0%, and Company B is yielding 3% above the cost of capital. In this case, Company B makes more sense to invest in since it is using its capital more efficiently to generate returns for stakeholders.
Takeaway
WACC is like the bar in the high jump...
WACC sets the lowest bar (rate of return) a company needs to get over in order to make a positive return on their investment. Anything below this bar means they should probably be putting their money elsewhere.
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How do you calculate WACC?
The formula for WACC involves several elements, including a company’s equity, debt and tax rate. These are then weighted proportionately, giving you an overall cost of capital.
The formula for WACC is:
The formula can seem a bit confusing at first, but it’s easier once you understand a little more about each part and how to arrive at those numbers.
The market value of equity: This is the value of all of the outstanding shares of the company. Sometimes this is referred to as market capitalization. To get the current market value of equity, you multiply total shares outstanding by the current stock price.
Cost of equity: This is usually the required rate of return that a company uses to decide whether a business investment is worthwhile or not. There are two different ways to calculate it.
- The first is the Dividend Capitalization Model. You generally use it for a company that issues dividends. You calculate it as:
- The second is the Capital Asset Pricing Model (CAPM). This can be used for any company, whether they issue dividends or not. The formula is:
The market value of debt: This is the total value of the company’s Debt, including loans and bonds. You can find this on a company’s balance sheet.
Cost of Debt: This is the effective interest rate that a company is paying for its debt. You also need to take taxes into account with this. So the formula would look like:
The total value of financing: Here, you add the market value of equity + the market value of debt.
Effective tax rate: This is the average tax rate that a company is paying. The formula is income tax expense divided by earnings before taxes (EBT).
How do you calculate WACC using financial statements?
You can find several of the pieces you need for the WACC formula on a company’s balance sheet and income statement. These give you the debt and tax side of the WACC formula.
| Balance Sheet | Income Statement |
| The total value of debt including loans and bonds | Interest expense, Income tax expense, Earnings before taxes |
In addition to these, you’ll need to find information about the value and the Cost of Equity. You can generally find this type of information on financial sites such as Nasdaq or Yahoo finance, including market capitalization and beta.
Once you’ve collected and calculated the different elements of the formula, you’re ready to move on to the WACC formula.
For example, let’s say you are analyzing Company A to see whether or not you want to invest. You know there are basically three parts you need to know; debt, equity, and taxes. You can go to the balance sheet and income statement to collect the info you need about the market value of debt, cost of debt, and tax rate.
First, let’s figure out the total value of financing or how the company finances its operations. The balance sheet shows a total value of debt of $25 million. The current market capitalization is $185 million. This gives a total value of financing of $210 million. Equity is 88% of the total financing, and debt is 12%.
To calculate the cost of debt, you can divide the company’s interest expense by total debt. You can find the debt on the balance sheet and the interest expense from the income statement. Let’s assume an interest expense of $1 million, and we already know the total debt of $25 million. So $1 million / $25 million = 4%.
Also, we need the tax rate. You find this by checking the income statement and dividing the income tax expense by earnings before taxes (EBT). Company A has an income tax expense of $30 million and earnings before taxes of $100 million. Effective tax rate = $30 million / $100 million = 30%
Next, let’s calculate the cost of equity. Company A doesn’t issue dividends, so we’ll use the Capital Asset Pricing Model (CAPM). This uses the company’s beta, a risk-free rate of return, and the expected return of the market. Let’s assume the company’s beta is 1.2, the risk-free rate is 3%, and the market return is 7%. So the cost of equity = 2% + 1.2 x (7% - 2%) = 7.5%.
Now let’s bring it all together to calculate the WACC.
WACC = ((88% x 7.5%) + (12% x 4%)) x (1-30%) = 6.9%
How to calculate WACC in Excel
First you need to check the balance sheet, income statement and relevant financial sites to collect all of your data.
Next, you add the market value of Equity and Debt together to find the total value of financing.
Then you calculate the percentage of financing that comes from Equity and Debt, by dividing the market value of each of those figures by the total value of financing.
Then you calculate the Cost of Equity which is the risk-free rate + (Beta x (expected market return - risk-free rate).
After this, you determine the Cost of Debt, which is the interest expense / market value of Debt.
Next, you calculate the tax rate dividing the income tax expense by the earnings before taxes.
Finally, you’re ready to calculate WACC which is (market value of equity / total value of financing) x cost of equity + (market value of debt / total value of financing) x cost of debt x (1-tax rate)
How is WACC different than Cost of Capital?
The cost of capital is the total cost of debt and equity that it takes for a company to finance its operations. It does not take into account the different weighting of each of those elements. Many companies use this as an internal discount rate or hurdle rate for making investment decisions. This means the project they are financing should have a return higher than the cost of capital.
WACC is very similar but takes the cost of capital one step further by weighting the debt and equity based on the proportion of the total financing. This means that if a company’s capital structure is 22% debt and 78% equity, then the WACC will reflect this weighting.
How is WACC different than Required Rate of Return?
WACC is most often used by companies to evaluate internal investment projects. It is generally the minimum rate of return that a project needs to have to make it a sound investment.
The required rate of return is typically used by investors and is the minimum return that an investor expects. An investor typically takes a risk-free asset, such as a Treasury bill, and adds a risk premium (additional return required to buy a riskier asset) to it. This helps take into account the additional risk they are taking to invest in the asset.
What are the limitations of WACC?
The most significant limitation of WACC is that several of the elements can be subjective or calculated in a different way. This means that various analysts may come up with different values. For example, analysts may have a particular or proprietary way of coming up with effective tax rates or may rely on different risk-free rates. So while it is a useful calculation for both investors and companies, it should also be used with other financial tools to determine whether or not to make an investment decision.
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