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Weighted Average Cost of Capital (WACC): Definition, Formula, Examples
The Weighted Average Cost of Capital (WACC) is the cost of capital from all sources - stocks, preferred stocks, bonds, and other instruments - after tax has been applied to the cost of debt. Each source of debt and equity are proportionally weighted in creating the average.
QUOTE
The cost of capital is what it costs us to obtain funds, either by selling stock, borrowing money, or retaining earnings. It’s our hurdle rate for making investment decisions.
Big ideas
- WACC can be used to determine the Required Rate of Return (RRR), as it neatly expresses what bondholders/shareholders need to receive in return for their Capital Expenditures (CapEx).
- WACC is calculated by multiplying the cost of each capital source by its weight in the capital structure. Results are added together and averaged to find the overall WACC. It is a comprehensive formula that takes corporate tax into account.
- The WACC calculation suffers from certain limitations. Certain parts of the formula, particularly the cost of equity, are inconsistent. Plus, the more complex a company’s capital structure, the more difficult the calculation becomes.
Understanding WACC and its importance in financial analysis
WACC plays a key role in financial analysis alongside the Capital Asset Pricing Model (CAPM). In a single figure, WACC expresses what a company pays to finance its operations.
The terms WACC and Cost of Capital are largely synonymous since WACC is the most comprehensive formula that includes both debt and equity. It is the minimum a company needs to earn to satisfy creditors and other capital providers to prevent them from going elsewhere.
The terms WACC and Cost of Capital are largely synonymous since WACC is the most comprehensive formula that includes both debt and equity. It is the minimum a company needs to earn to satisfy creditors and other capital providers to prevent them from going elsewhere.
The WACC can be used for different purposes:
1. Companies depend on it to see if the Required Rate of Return (RRR) on specific investment projects is worthwhile.
2. Management can calculate the WACC to determine whether to rely on debt or equity financing.
The formula plays an essential role in Discounted Cash Flow (DCF) analysis, which is fundamental to company valuation. It is central to Mergers and Acquisitions (M&A), drives the equity market, is a core part of the ROIC/WACC performance metric, and is relied upon by financial professionals globally.
1. Companies depend on it to see if the Required Rate of Return (RRR) on specific investment projects is worthwhile.
2. Management can calculate the WACC to determine whether to rely on debt or equity financing.
The formula plays an essential role in Discounted Cash Flow (DCF) analysis, which is fundamental to company valuation. It is central to Mergers and Acquisitions (M&A), drives the equity market, is a core part of the ROIC/WACC performance metric, and is relied upon by financial professionals globally.
Components of WACC
Different securities come with different risk/return profiles and the WACC takes these profiles into account. The WACC has three major elements:
1. Cost of equity
2. Cost of debt
3. The weighting of each security component
Preferred stock is another component in the WACC formula, acting as a hybrid between equity and debt.
If a company only uses one source, such as common stock, the calculation is straightforward. Yet this is rarely the case, with companies relying on both debt and equity as a form of funding, in various proportions.
The formula gets trickier to work with depending on the complexity and proportion of the capital structure: 90/10, 50/50, 25/75, etc. Keep in mind that the default convention is equity/debt, not debt/equity.
1. Cost of equity
2. Cost of debt
3. The weighting of each security component
Preferred stock is another component in the WACC formula, acting as a hybrid between equity and debt.
If a company only uses one source, such as common stock, the calculation is straightforward. Yet this is rarely the case, with companies relying on both debt and equity as a form of funding, in various proportions.
The formula gets trickier to work with depending on the complexity and proportion of the capital structure: 90/10, 50/50, 25/75, etc. Keep in mind that the default convention is equity/debt, not debt/equity.
1. Cost of equity
The cost of equity represents the return investors expect from investing in a company’s stock. It reflects the risk premium shareholders expect when they choose equity instead of lower-risk investments. The most common way to calculate the cost of equity is by using the CAPM model.
This formula includes the risk-free rate, the stock’s beta, and the expected market return. The result gives an idea of the return equity investors demand for taking the risk of investing in the company. It is a crucial part of the WACC because equity typically requires a higher return compared to debt.
This formula includes the risk-free rate, the stock’s beta, and the expected market return. The result gives an idea of the return equity investors demand for taking the risk of investing in the company. It is a crucial part of the WACC because equity typically requires a higher return compared to debt.
2. Cost of debt
The cost of debt refers to the actual interest rate a company incurs on its borrowed funds. It includes loans, bonds, or other forms of debt. Companies often pay a lower rate for debt compared to equity since lenders are paid before shareholders in the event of liquidation.
To calculate the cost of debt, a company takes its average interest rate and adjusts it for taxes, as interest payments are tax-deductible. This tax adjustment makes debt a relatively cheaper component of WACC. However, too much reliance on debt can increase financial risk, impacting the company’s long-term stability.
To calculate the cost of debt, a company takes its average interest rate and adjusts it for taxes, as interest payments are tax-deductible. This tax adjustment makes debt a relatively cheaper component of WACC. However, too much reliance on debt can increase financial risk, impacting the company’s long-term stability.
3. The weighting of each WACC component
The weighting in WACC refers to the proportion of each type of financing a company uses - equity, debt, and preferred stock.
These proportions are based on the company’s capital structure. For example, if a company uses more debt, the WACC formula will reflect a higher weight for the cost of debt.
When thinking about this - just remember that the overall goal is to find the average cost of capital that reflects how a company finances its operations.
Each component is multiplied by its respective weight and added together. The final WACC figure represents the blended cost of capital from all sources, helping investors evaluate whether the company is using its financial resources efficiently.
These proportions are based on the company’s capital structure. For example, if a company uses more debt, the WACC formula will reflect a higher weight for the cost of debt.
When thinking about this - just remember that the overall goal is to find the average cost of capital that reflects how a company finances its operations.
Each component is multiplied by its respective weight and added together. The final WACC figure represents the blended cost of capital from all sources, helping investors evaluate whether the company is using its financial resources efficiently.
A quick primer on preferred stock
Preferred stock is a hybrid between equity and debt. Holders of preferred stock are entitled to dividends before common shareholders but have less voting power. Dividends on preferred stock are often fixed, making the cost of preferred stock relatively stable and predictable.
In the WACC formula, the cost of a preferred stock is calculated by dividing the preferred dividend by the price of preferred shares. Though typically more expensive than debt, preferred stock can be less costly than equity, providing a balance between the two. It is another tool companies use to finance their operations without adding too much financial risk.
In the WACC formula, the cost of a preferred stock is calculated by dividing the preferred dividend by the price of preferred shares. Though typically more expensive than debt, preferred stock can be less costly than equity, providing a balance between the two. It is another tool companies use to finance their operations without adding too much financial risk.
Weighted Average Cost of Capital (WACC) calculation step by step
The WACC calculation relies on the CAPM to calculate the cost of equity, which includes the risk-free rate, the stock’s beta, and the expected market return.
This is less reliable than the cost of debt, which is easier because debt financing is much more stable, with returns paid out at a fixed rate known in advance.
WACC Formula
FORMULA
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where:
• E = market value of the firm’s equity
• D = market value of the firm’s debt
• V = total value of capital (E + D)
• E/V = percentage of capital that is equity
• D/V = percentage of capital that is debt
• Re = cost of equity
• Rd = cost of debt
• T = corporate tax rate
Where:
• E = market value of the firm’s equity
• D = market value of the firm’s debt
• V = total value of capital (E + D)
• E/V = percentage of capital that is equity
• D/V = percentage of capital that is debt
• Re = cost of equity
• Rd = cost of debt
• T = corporate tax rate
WACC formula for different types of business
The WACC formula remains consistent across businesses but differs based on capital structure and risk.
Companies use more debt in asset-heavy sectors like utilities, benefiting from lower interest rates and tax deductions. This results in a lower WACC. In contrast, tech companies may rely more on equity due to higher volatility, which increases the cost of equity and results in a higher WACC.
Companies use more debt in asset-heavy sectors like utilities, benefiting from lower interest rates and tax deductions. This results in a lower WACC. In contrast, tech companies may rely more on equity due to higher volatility, which increases the cost of equity and results in a higher WACC.
How to calculate WACC for publicly traded companies
For publicly traded companies, WACC is easier to calculate because market data is publicly available. The cost of equity is usually estimated using CAPM, which incorporates the company’s beta, risk-free rate, and expected market return. Debt costs are derived from bond yields or loan interest rates.
FORMULA
Cost of equity (CAPM) = Rf + β × ( Rm − Rf)
Where:
• Rf = risk-free rate
• β = beta
• Rm = market return
Where:
• Rf = risk-free rate
• β = beta
• Rm = market return
For example, British American Tobacco’s (BAT) WACC can be calculated by using the company’s beta, the UK government bond yield as the risk-free rate, and the interest rates on its bonds to reflect the cost of debt. The equity and debt proportions/weightings come from the company’s financial statements.
EXAMPLE
To calculate BAT’s WACC as of October 2024, we start by estimating the cost of equity using the CAPM formula, based on the following assumptions:
• Risk-free rate = 2%
• Beta = 0.9
• Market return = 7%
• Weighting = 60/40
• Corporate tax = 19%
Application & Interpretation
The cost of equity would be 2% + 0.9 x (7% - 2%) = 6.5% as per CAPM.
BAT’s cost of debt is derived from its bond yields, averaging around 4%. After adjusting for the corporate tax rate of 19%, the after-tax cost of debt becomes 4% x (1 - 0.19) = 3.24%.
BAT’s capital structure is 60% equity and 40% debt. The WACC is calculated as: 0.6 x 6.5% + 0.4 x 3.24%, resulting in a WACC of approximately 5.2%.
This reflects BAT’s use of a mix of equity and debt, balancing its risk and capital costs effectively.
Past performance is no guarantee of future results. This information is not investment advice. Do your own research.
• Risk-free rate = 2%
• Beta = 0.9
• Market return = 7%
• Weighting = 60/40
• Corporate tax = 19%
Application & Interpretation
The cost of equity would be 2% + 0.9 x (7% - 2%) = 6.5% as per CAPM.
BAT’s cost of debt is derived from its bond yields, averaging around 4%. After adjusting for the corporate tax rate of 19%, the after-tax cost of debt becomes 4% x (1 - 0.19) = 3.24%.
BAT’s capital structure is 60% equity and 40% debt. The WACC is calculated as: 0.6 x 6.5% + 0.4 x 3.24%, resulting in a WACC of approximately 5.2%.
This reflects BAT’s use of a mix of equity and debt, balancing its risk and capital costs effectively.
Past performance is no guarantee of future results. This information is not investment advice. Do your own research.
WACC calculation challenges for private companies
Private companies don’t have publicly available market data, making WACC calculations more complex. Without a listed stock, it is difficult to estimate the cost of equity. Instead, analysts may use industry averages or comparables. Debt costs are typically calculated based on private loan agreements.
For example, a mid-sized UK construction company might estimate its WACC by using industry benchmarks for beta and borrowing rates based on its credit profile. The weighting of equity and debt would be determined by the company’s internal financial structure, which may differ from public firms.
For example, a mid-sized UK construction company might estimate its WACC by using industry benchmarks for beta and borrowing rates based on its credit profile. The weighting of equity and debt would be determined by the company’s internal financial structure, which may differ from public firms.
EXAMPLE
Assumptions for a mid-sized UK construction firm, with the cost of equity inferred from industry benchmarks and the cost of debt inferred from private loans:
• Cost of equity = 12%
• Cost of debt (pre-tax) = 6%
• Weighting = 50/50
• Corporate tax = 19%
Application & Interpretation
The cost of debt after tax is then calculated as follows: 6% x (1 - 0.19) = 4.86%.
There is a 50% capital split; therefore, the WACC formula would be: 0.5 x 12% + 0.5 x 4.86% = 8.43%.
The calculations are hypothetical and intended solely for educational use.
• Cost of equity = 12%
• Cost of debt (pre-tax) = 6%
• Weighting = 50/50
• Corporate tax = 19%
Application & Interpretation
The cost of debt after tax is then calculated as follows: 6% x (1 - 0.19) = 4.86%.
There is a 50% capital split; therefore, the WACC formula would be: 0.5 x 12% + 0.5 x 4.86% = 8.43%.
The calculations are hypothetical and intended solely for educational use.
WACC for startups and growth companies
Startups and growth companies face unique challenges when calculating WACC. They typically have little debt, so the cost of equity is the primary factor. These companies often have higher risk profiles, which means the cost of equity can be substantial.
A UK biotech startup, for example, might have a WACC based mostly on the cost of equity, with a high-risk premium due to market uncertainty and the lack of stable cash flows. Since debt is minimal, WACC remains high, reflecting the risks and growth potential of these types of companies.
A UK biotech startup, for example, might have a WACC based mostly on the cost of equity, with a high-risk premium due to market uncertainty and the lack of stable cash flows. Since debt is minimal, WACC remains high, reflecting the risks and growth potential of these types of companies.
EXAMPLE
A UK biotech startup will have a high equity cost and a low debt, with a higher weighting in equity than debt:
• Cost of equity = 15%
• Cost of debt (pre-tax) = 7%
• Weighting = 90/10
• Corporate tax = 19%
Application & Interpretation
After accounting for a tax rate of 19%, the after-tax cost of debt is 7% x (1 - 0.19) = 5.67%. With a 90/10 equity-to-debt ratio, the WACC formula is: 0.9 x 15% + 0.1 x 5.67%, resulting in a WACC of 14.07%.
This reflects the higher cost of capital due to the significant reliance on equity and the risk profile typical of startups.
The calculations are hypothetical and intended solely for educational use.
• Cost of equity = 15%
• Cost of debt (pre-tax) = 7%
• Weighting = 90/10
• Corporate tax = 19%
Application & Interpretation
After accounting for a tax rate of 19%, the after-tax cost of debt is 7% x (1 - 0.19) = 5.67%. With a 90/10 equity-to-debt ratio, the WACC formula is: 0.9 x 15% + 0.1 x 5.67%, resulting in a WACC of 14.07%.
This reflects the higher cost of capital due to the significant reliance on equity and the risk profile typical of startups.
The calculations are hypothetical and intended solely for educational use.
Recap
The WACC is a comprehensive and widely used tool for financial analysis. Professionals within investment banking, equity research, corporate development, and private equity will certainly be familiar with it.
WACC is most frequently used by companies to determine which investment projects are viable. However, despite its prevalence, it is not as useful for private companies and startups due to the lack of public information.
Plus, calculating the cost of equity relies on historical data, which is not an absolute indicator of future performance. Like all financial metrics, it needs to be used in conjunction with other formulas, potentially with more specialised insights and analysis pertaining to both the industry and the company.
WACC is most frequently used by companies to determine which investment projects are viable. However, despite its prevalence, it is not as useful for private companies and startups due to the lack of public information.
Plus, calculating the cost of equity relies on historical data, which is not an absolute indicator of future performance. Like all financial metrics, it needs to be used in conjunction with other formulas, potentially with more specialised insights and analysis pertaining to both the industry and the company.
FAQ
Q: What is the Weighted Average Cost of Capital (WACC)?
The WACC is a firm's overall cost of capital, calculated by averaging the costs of equity and debt, weighted by their proportion in the company’s capital structure. It reflects the minimum return required by investors and lenders to justify investing in the business.
Q: Is a higher WACC good or bad?
A higher WACC is generally considered bad, as it indicates that the company has a higher cost to finance its operations. This can mean more risk for investors and make it harder for the business to generate value through new projects or investments.
Q: What is a good WACC?
A "good" WACC varies by industry and market conditions. Typically, a lower WACC is desirable, as it suggests cheaper financing. Companies in stable industries or with strong financials tend to have lower WACCs, often below 10%, while riskier ventures may face higher rates.
Q: How does WACC serve as a hurdle rate?
WACC serves as a hurdle rate by representing the minimum return a company must earn on an investment to cover its capital costs. If a project’s expected return is lower than the WACC, it would reduce the value, whereas returns above the WACC add value.
Q: What is the difference between nominal vs. real WACC?
Nominal WACC includes the effects of inflation and represents the overall return required by investors in current monetary terms. Real WACC removes inflation’s effect and reflects the true purchasing power return required by investors. Real WACC is typically used in inflation-adjusted or real-term investment appraisals.
- Capital Asset Pricing Model (CAPM): A framework used to estimate the cost of equity by linking a share’s expected return to how much it moves relative to the overall market.
- Capital structure: How a company finances itself, typically through a mix of equity, debt, and sometimes other instruments like preferred shares.
- Market return: The average performance or return of the entire stock market, often measured using a broad index such as the FTSE 100 or S&P 500.
- Capital Expenditures (CapEx): Funds used by a company to acquire, upgrade, or maintain physical assets such as property, equipment, or technology. These investments are essential for business expansion and long-term growth.
