Weighted Average Cost of Capital
The Weighted Average Cost of Capital (WACC) is a financial metric that represents the average after-tax cost of a company’s various sources of capital, including debt and equity. The WACC serves as the discount rate used in financial models, such as discounted cash flow (DCF) analysis, to evaluate the present value of a firm’s future cash flows. It provides a comprehensive measure of the cost of capital that a firm must earn on its investments to satisfy its creditors, owners, and other capital providers.
The WACC is calculated by taking the weighted average of each category of capital that the business uses, considering the cost of each type. The general formula for WACC is:
WACC = (Wd × Rd × (1 − Tc)) + (We × Re)
Where:
- Wd = Weight of debt in the capital structure
- Rd = Cost of debt (interest rate)
- Tc = Corporate tax rate
- We = Weight of equity in the capital structure
- Re = Cost of equity (often estimated using the Capital Asset Pricing Model, or CAPM)
Example of Weighted Average Cost of Capital
Let’s look at a simplified example to understand how the Weighted Average Cost of Capital (WACC) is calculated.
Company XYZ Financials:
- Debt: $1 million with an annual interest rate of 4%
- Equity: $4 million with an expected return of 8%
- Corporate Tax Rate: 25%
Step 1: Calculate the Weights
First, we’ll calculate the weights of debt and equity in the overall capital structure.
- Total Capital: Debt + Equity = $1,000,000 + $4,000,000 = $5,000,000
- Weight of Debt Wd: $1,000,000 / $5,000,000 = 0.2
- Weight of Equity We: $4,000,000 / $5,000,000 = 0.8
Step 2: Use the WACC Formula
Now we’ll use the WACC formula:
WACC = (Wd × Rd × (1 − Tc)) + (We × Re)
- Wd = 0.2
- Rd=0.04 (4% cost of debt)
- Tc=0.25 (25% tax rate)
- We = 0.8
- Re = 0.08 (8% cost of equity)
Plug these values into the formula:
WACC = (0.2 × 0.04 × (1 − 0.25)) + (0.8 × 0.08)
WACC = (0.2 × 0.04 × 0.75) + (0.8 × 0.08)
WACC = (0.2 × 0.03) + (0.8 × 0.08)
WACC = 0.006 + 0.064
WACC = 0.07 or 7%
Summary:
Company XYZ has a WACC of 7%. This means that the company needs to earn at least a 7% return on its total capital to satisfy its debt holders and equity holders, as well as to cover the costs of its capital.
By knowing its WACC, the company can make informed decisions about which investments it should undertake, provided that the projects yield a return higher than 7%.
