Weighted Average Cost of Capital (aka WACC) – perhaps one of the most dreaded concepts, especially for people who are new to Finance and Investing. It’s actually pretty straightforward and simple once you get your head around it. Here’s everything you need to know about it, including what it is, why it’s important, and how to calculate it.
What is WACC (Weighted Average Cost of Capital)?
Firstly, what is WACC (aka Weighted Average Cost of Capital)?
As with most things in Finance and Investing, the clue’s in the name.
The WACC is a:
- Weighted Average
- Cost of Capital
Let’s consider both of these parts individually.
A weighted average is nothing but an average that’s weighted by some “weighting factor”.
For example, to calculate portfolio returns, we essentially calculate a weighted average of the returns of assets that make up the portfolio.
So you’d calculate stock returns for each stock that’s in the portfolio, and then multiply those individual stock returns by a “weighting factor”.
The “weighting factor” for portfolio returns is the proportion invested in a given asset.
In the context of WACC, the “weighting factor” is the Capital Structure of a firm.
Now, if you don’t know what “Capital Structure” is, don’t worry. We’ll briefly touch on it further down. If you’d like to dive deeper into the Capital Structure of a firm, then do check out the article we’ve linked to.
For now, it’s sufficient if you know that a weighted average is simply an average that’s weighted by some “weighting factor”.
Let’s think about the Cost of Capital now.
Cost of Capital
Cost of Capital represents the cost… of capital.
Specifically, it reflects the cost of raising capital.
Put differently, it displays the cost of raising finance – from both debt as well as equity.
Establishing the cost of raising equity finance exclusively is achieved by looking at the Cost of Equity.
For Debt, we can establish the cost of debt financing by using the Cost of Debt.
But if we want to explore the cost of raising both Debt and Equity financing, then we’ll want to look at the Cost of Capital.
And because there’s some proportion of debt finance vs. equity finance raised, it’s important to weigh the Cost of Capital by the proportion of any given type of financing.
Put simply, we’ll want to weigh the cost of capital by the way the firm’s financing is structured.
This is apparent from a firm’s Capital Structure.
What is Capital Structure?
Capital Structure is a fancy word to represent the way in which a firm’s capital is structured.
Put simply, it allows an investor (or anyone) to see if a firm is funded by:
- Equity, or
- Both Debt and Equity.
It allows us to see what proportion of the capital is funded by debt vs. equity.
Capital Structure can broadly be represented in two different ways, including:
- Debt as a proportion of total capital
- Equity as a proportion of total capital
The difference between the two versions is purely to do with how we want to describe Capital Structure.
If one wants to highlight the prevalence of debt relative to total capital, we’ll want to use Debt as a proportion of Total Capital.
If, on the other hand, one wants to highlight the prevalence of equity relative to total capital, then you’ll want to use the second representation – Equity as a proportion of Total Capital.
Let’s consider each of these representations of capitals structure.
Debt as a proportion of total capital
Here, Capital Structure can be represented as:
- represents the market value of Debt
- reflects the market value of Equity (aka Market Capitalization)
Adding Debt and Equity () will give us the value for Total Capital.
That in turn is equivalent to Total Assets, given the Accounting Equation.
Equity as a proportion of total capital
Capital Structure can also be represented as:
- still represents the market value of Debt, and
- continues to reflect the market value of Equity
Adding Debt and Equity () will still give us the value for Total Capital.
Why Is WACC (Weighted Average Cost of Capital) Important?
The WACC (or Weighted Average Cost of Capital) is crucial for 2 main user groups, including:
- investors, and
Importance of WACC for Investors
For investors, the WACC often represents the appropriate discount rate when valuing companies.
Note that it would not be the most appropriate discount rate for the valuation of stocks.
Valuation of stocks, at least when using a Discounted Cash Flows (DCF) approach, will tend to use the Cost of Equity as the appropriate discount rate.
To value a company as a whole, however, investors and analysts will typically use the WACC as the appropriate cost of capital.
So, for example, if you were trying to calculate Enterprise Value for a company, you’d typically need to use the WACC.
Now, as a result of being the “cost” of raising finance for companies, the cost of capital is equivalent to the rate of return for investors.
Thus, although the WACC is primarily seen as a cost of capital, it can also be seen as a rate of return for investors.
Importance of WACC for Companies
The WACC is a crucial metric for companies, primarily because it gives them a clear number for the cost of raising finance.
As an example, if the WACC for a firm is say, 10%, then it means it would cost the firm $0.10 for every $1 of finance raised.
This accounts for both debt and equity finance of course.
Companies may also choose to use the WACC as the appropriate discount rate for capital budgeting techniques.
So, for example, if a company is thinking about how to calculate NPV for an investment project it’s evaluating, then it can use the WACC as the appropriate discount rate.
This Harvard Business Review article sheds some interesting light on the approach taken to determine appropriate values for capital budgeting tools in practice. If you’re interested in that, do give it a read.
You may also want to check out our Investment Appraisal course where we teach capital budgeting techniques from scratch.
For now though, let’s think about how to calculate WACC.
How to Calculate WACC (Weighted Average Cost of Capital)?
The WACC actually has many different representations and formulas. We’ll explore all the varieties in a bit, but let’s start with a simple WACC formula.
We can calculate WACC by using this formula:
- represents the Weighted Average Cost of Capital
- reflects the market value of Debt
- denotes the market value of Equity
- represents the cost of equity, and
- reflects the cost of debt
Remember how we said that the WACC is a weighted average… cost of capital?
And how a weighted average is an average that’s weighted by some “weighting factor”?
Hopefully, you can now actually see this in the formula.
The weighting factor in the WACC formula is the capital structure (the fractions of debt and equity over total capital).
We multiply the individual cost of equity and cost of debt by their respective/associated capital structures.
So, the cost of debt () is multiplied by the proportion of debt relative to total capital.
And the cost of equity ( is multiplied by the proportion of equity relative to total capital.
Alternative Formula for WACC
Note that some people prefer to write the cost of equity and cost of debt as and respectively.
In such an instance, the WACC formula can be written out as:
The WACC formula here is identical to the one we provided earlier.
The only difference is that we’re writing the cost of equity and cost of debt as and instead of and .
Writing it as and sees things from the investor’s perspective.
We – and many others like us – prefer to use the letter instead of because tends to represent cost in financial economics.
Nuances around notations aside, the formula above is one of the simplest ways to represent the WACC. But there are a few other ways of writing the WACC formula.
Alternative Expressions of WACC Formula
There are a few different representations of the WACC formula. Variations broadly come as a result of:
- considerations of taxes, and
- differences in notations
Impact of Tax on the WACC Formula
If we consider the impact of tax – and in particular, consider the interest tax shield – then we can calculate WACC as:
The formula here is identical to the formula for WACC from earlier, except that there’s an additional variable .
here represents the corporation tax rate.
By multiplying by we get to what’s called the after-tax cost of debt.
Long story short, interest expense is tax deductible. This reduces the tax bill for a company, and thus, essentially, reduces the cost of borrowing.
If you want to learn more about how the interest tax shield works, check out the sister article we’ve linked to.
Different Notations for the WACC Formula
Some people prefer to think of the WACC formula in a way that represents the value of a firm.
Thus, rather than thinking about the denominator as “total capital”, some people prefer to see it as the “value of the firm”.
With that interpretation, the WACC formula can be written as:
This, of course, ignores the effects of taxation. But if we were to consider the impact of the interest tax shield, then we can write the formula for WACC as:
The only difference between these versions and the ones we wrote out earlier, is the term .
The value of the firm is nothing but the value of debt plus the value of equity.
It’s merely a different way of writing out .
Extending on this idea of thinking about the WACC formula in terms of the “value of the firm” instead of capital, we can also write the WACC formula as:
Here, rather than writing the market values of debt and equity as and respectively, we’re just writing them as and .
is equivalent to , and is equivalent to . It’s just using a different letter or writing style if you will.
Some go as far as writing to explicitly state that it’s the Market Value. This way, the WACC formula is written out as:
You get the idea. Let’s now look at how to calculate WACC with an example.
How to Calculate WACC – Example Walkthrough
Consider Starmont Inc., which recently announced its intention to pay dividends of $2.50 per share every year for the foreseeable future, for each of its 100m shares. Some analysts believe that the company may increase its dividends by up to 5% each year. They base this on the firm’s high amount of available capital, including $800m of debt (based on recent market valuations) and total assets of $3.5bn in current market value terms.
The firm’s positive exposure to the market, given its beta of 1.25, means it’s poised for strong performance ahead. Analysts expect the overall market return to be 12%per year over the coming years. Yields on risk-free securities are reported at 1.5%.
Analysts from EveningStar Inc. estimate the firm’s cost of equity to be 11.78% and its cost of debt to be 4%.
What is Starmont Inc.’s Cost of Capital (WACC)?
The question provides sufficient information for you to calculate using the formula provided earlier.
So go on! Give it a go and try estimating Starmont Inc.’s cost of capital on your own.
Hint: we’ve bolded items in the question for a very good reason! 😉
We’re going to assume you did that, so let’s go ahead now and solve it together.
WACC Calculation Example Walkthrough
We’re told that the market value of debt () is equal to $800m.
Total Assets (being given the accounting equation) is equal to $3.5bn.
We can subtract the value of debt from total assets to calculate the value for .
In other words…
Rearranging for gives us…
Given a value for , we can solve for as…
Now we have everything we need to calculate WACC. Plugging in the numbers into the formula for WACC, we have…
This is equivalent to writing it as…
Solving for this gives us a value of approximately 10%.
Thus, Starmont Inc.’s WACC = 10%.
NOTE: if you’ve already read our sister articles on the Definitive Guide to Cost of Equity and on the Cost of Debt, please note that there are minor differences between the example question here vs. the ones in those articles. We’ve tried to maintain a large level of similarity so you can explore how the Cost of Equity, Cost of Debt, and Cost of Capital/WACC interact.
Wrapping Up – WACC
In summary, you learned that the WACC (aka Weighted Average Cost of Capital) is a cost of capital that’s weighted by a firm’s capital structure.
The formula for WACC is as follows:
Of course, this isn’t the only formula for WACC in that there can be many different representations of it.
But the WACC formula provided above is very commonly used as “the” WACC formula.
You’ve learned how the WACC is used as an appropriate discount rate for valuing companies and appraising projects.
Finally, of course, you applied your knowledge by learning how to calculate WACC.
If any part of this article isn’t quite clear, please give it another read.
That’s a wrap from us for now though. Keep learning, and growing!
If you want to further your understanding of finance and investing, do check out our investing courses, designed to help you invest like a PRO.
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