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Home > Balance Sheets Checklists > Understanding the Weighted Average Cost of Capital (WACC)

Balance Sheets Checklists

Understanding the Weighted Average Cost of Capital (WACC)


Checklist Description

This checklist explains the weighted average cost of capital.

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Definition

The weighted average cost of capital (WACC) measures the capital discount of a company’s income and expenditure. It is a component of the formula used for calculating the expected cost of new capital and it represents the rate that a company is expected to pay to finance its assets. It is thus the minimum return that a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital.

WACC is calculated by taking into account the relative weight of each component of a company’s capital structure. The calculation usually uses the market values of the components, rather than their book values, which may differ significantly. Components may include equity (both common and preferred), debt (straight, convertible, or exchangeable), warrants, options, pension liabilities, executive stock options, and government subsidies. More exotic sources of financing, such as convertible/callable bonds or convertible preferred stock, may also be included in a WACC calculation if they are present in significant amounts as the cost of these is usually different from plain vanilla financing methods. For a company with a complex capital structure, calculating WACC can be a time-consuming exercise.

The equation used to calculate WACC uses the cost of each capital component multiplied by its proportional weight as follows:

WACC = E/V × Re + D/V × Rd × (1 − Tc)

where Re is the cost of equity, Rd is the cost of debt, E is the market value of the firm’s equity, D is the market value of the firm’s debt, V = E + D, E/V is the percentage of financing that is equity, D/V is the percentage of financing that is debt, and Tc is the corporate tax rate.

To determine the value of each component it is assumed that the weight of a source of financing is simply its market value (rather than the book value, which may be significantly different) divided by the sum of the values of all the components. The easiest component to calculate is the market value of the equity of a publicly traded company, as this is simply the price per share multiplied by the number of outstanding shares. Likewise, the market value of preferred shares is easy to determine and is calculated by multiplying the cost per share by number of outstanding shares. The market value of a company’s debt is also easy to discover if a company has publicly traded bonds. However, many companies have debt in the form of bank loans, whose market value is not easily found. However, the market value of debt is often fairly close to the book value, at least for companies that have not experienced significant changes in credit rating. Thus, calculation of WACC typically uses the book value of any debt.

On the cost side, the cost of preferred shares is calculated by dividing the periodic payment by the price of the preferred shares. The cost of ordinary shares is typically determined using the capital asset pricing model. The cost of debt is usually the yield to maturity on the company’s publicly traded bonds, or the rates of interest charged by the banks on recent loans. The cost of debt can be cut further as a company can usually write off taxes on the interest it pays on the debt. Thus, the cost of debt is calculated as yield to maturity multiplied by (1 minus the tax rate).

Because governments usually allow tax to be deducted from interest, there is an inherent bias towards debt financing. However, the cost of financial distress, such as bankruptcy, tilts any bias towards equity financing. In theory, therefore, the ideal debt-to-equity ratio in a company is usually the point at which any tax benefits accrued by debt financing are outweighed by the costs of financial distress.

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Further reading

Books:

  • Armitage, Seth. The Cost of Capital: Intermediate Theory. Cambridge, UK: Cambridge University Press, 2005.
  • Johnson, Hazel. Determining Cost of Capital: The Key to Firm Value. London: FT Prentice Hall, 1999.
  • Pratt, Shannon P., and Roger J. Grabowski. Cost of Capital: Applications and Examples. 4th ed. Hoboken, NJ: Wiley, 2010.

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