What is WACC (Weighted Average Cost of Capital)?

What is WACC?

The Weighted Average Cost of Capital (WACC) is a formula used to calculate how much a company is going to pay for its financing. Meaning, it shows a firm’s cost of capital proportional to its financing mixture for every dollar financed.

In general, a firm’s financing will consist of a mixture between debt and equity. Simplistically, debt is a loan that will need to be repaid with interest while equity is the raising of money by selling interest in the company, theoretically to be repaid by increasing the value of the company and through dividends. Within the WACC formula, all sources of capital including bonds, common stock, preferred stock, and long-term debt are included. In reference to Investopedia, its formula is denoted

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D = total market value of the firm’s financing (equity and debt)

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

How to Use the Formula

Not to be redundant, but it is important, the Weighted Average Cost of Capital takes both debt and equity sources of capital. These sources are then proportioned into their respective buckets relative to total capital. Basically, a ratio of 1 or a percentage of 100% is created by these sources. The weights are simply the ratios of debt and equity the total amount of capital.

Example of Weighted Average Cost of Capital

For purposes of an example, let us suppose Duke Energy has common equity of $35.5 million, $10.3 million of preferred equity, and $31.9 million of long-term debt on its books. The required return on each of these is 12%, 10%, and 8%, respectively. The market values of the common equity are $46.6 million and for the long-term debt it is $35 million. The market value for the preferred equity is the same as its book value. Given the tax rate is 30%, what would the WACC be for Duke Energy?

To do this, it is important to lump money into their respective categories.

Common equity – $46.6 million

Preferred equity – $10.3 million

Long term debt – $35 million

Total capital – $91.9 million

WACC = (46.6/91.9) x 12% + (10.3/91.9) x 10% + (35/91.9) x 8% x (1-30%) = 9.34%

Why a Company Should Care about WACC?

A firm’s WACC is what is required from the firm as a form of repayment. From the example, the firm would have to pay what is essentially an interest rate of 9.34% on every dollar financed.

The WACC is used internally by management to evaluate expansion plans by the firm whether that be via merger or startup; it is a measure of economic feasibility.

The Weighted Average Cost of Capital is also used by both Securities Analyst and Investors. As far as Securities Analyst are concerned, their main objective is to study companies and industries in order to provide research and valuation reports all the while giving recommendations to investors on which companies to buy, sell, or hold. Securities Analysts use WACC in these recommendations.

Within discounted cash flow analysis, a Security Analyst could essentially interchange WACC as the discount rate for future cash flows. By doing so, the Security Analyst could derive a firm’s net present value (NPV). When gauging return on invested capital (ROIC), a Security Analyst can apply WACC as a hurdle rate to compare and contrast. On top of that, in the economic value added (EVA), WACC is a key component.

In a simplistic world, WACC, for investors, is the smallest rate of return in which the company finds acceptable to yield for its investors. Basically, by taking a company’s yielded return and subtracting WACC, one could use this information to determine whether or not it is prudent to invest in the company.

If the WACC is greater than the yielded return then the company is creating value which is good for the investor. If the WACC is less than the yielded return then the company is losing value which is bad for the investor; WACC is a reality check. However, it seems simple to calculate, but takes time to research each potential company’s WACC. Despite its difficulty, understanding the calculation can lead investors into well-managed companies with demanded goods and keep investors away from poorly-managed companies.

It is important to understand the limitations of WACC as well. Certainly, elements of the calculation are not universal across each company so that makes it difficult to fully get an apples-to-apples comparison. It is a valuable tool, but should not be the only tool used when trying to evaluate whether to invest or not; use other metrics.

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6 Comments

  • Quotes Tadka

    Reply Reply July 9, 2017

    Very nice article, exactly what I needed.

  • subtitles

    Reply Reply July 10, 2017

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  • Gadgets9

    Reply Reply July 14, 2017

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    • Brett

      Reply Reply July 14, 2017

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