A:

The weighted average cost of capital (WACC) is a financial metric that shows what the total cost of capital (that is, the interest rate paid on funds used for financing operations) is for a firm.

All companies need to finance operations, and this funding comes from two sources: debt or equity. Each source has a cost associated with it. When analyzing different financing options, whether through debt, equity, or a combination of both, calculating the WACC provides the company with its financing cost. Whatever the WACC rate ends up being, it is then used to discount the project or business in a valuation model. (Improve your excel skills by taking Investopedia's excel for finance courses.)

## WACC Calculation

The WACC takes into account both debt and equity sources of capital and the proportion of total capital each source represents. The weights are simply the ratios of debt and equity to the total amount of capital. As an equation, it would be expressed as:

WACC = wD*rD *(1-t) + wP*rP + wE*rE

where:

For debt capital, the cost is either the actual interest rate of the bonds, or the interest rate of comparable debt for a similar business. You reduce the cost of debt by (1 - tax rate) because interest payments on debt are tax-deductible, and this tax break lowers the debt's effective cost.

For equity funds, the cost of capital is more complicated because there is no stated interest rate. For preferred stock, you can calculate the cost as the dividend rate of the shares. Using the Capital Asset Pricing Model (CAPM), you can estimate the cost of equity.

In terms of capital cost, the scale from cheapest to most expensive runs: debt, preferred equity and finally equity.

## Calculating WACC in Excel

Calculating WACC is easy. As with most financial modeling, the most challenging part is getting the correct data to plug into the model.

Illustrated below is an example of the data needed to estimate a company's WACC. The after-tax cost of debt is found by looking for debt disclosures in the company filings; the costs should be stated there. The cost of equity is calculated with CAPM, as mentioned above. Total capital is calculated by adding the debt to the market value of the equity.

RELATED FAQS
1. ### What does a high weighted average cost of capital (WACC) signify?

Find out what it means for a company to have a relatively high weighted average cost of capital, or WACC, and why this is ... Read Answer >>
2. ### How do you calculate the ratio between debt and equity in the cost of capital

Discover how to calculate the ratio between debt and equity when making cost of capital estimations using the weighted average ... Read Answer >>
3. ### How do interest rates affect the weighted average cost of capital (WACC) calculation?

The interest rate is one of many external factors that can change the inputs in the weighted average cost of capital (WACC) ... Read Answer >>
4. ### Do companies measure their cost of debt with before- or after-tax returns?

Understand the before and after-tax calculations of cost of debt capital and how each is useful in deciding between funding ... Read Answer >>
5. ### What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
6. ### How does a company choose between debt and equity in its capital structure?

Learn about the benefits and drawbacks of debt and equity financing and how companies compare different capital structures ... Read Answer >>
Related Articles
1. Investing

### Investors Need A Good WACC

Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.
2. Managing Wealth

### Weighted Average Cost Of Capital (WACC)

Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality
3. Personal Finance

### Top Things to Know For an Investment Banking Interview

Without some basic knowledge, you won't get the job. Find out what you need to know and how to prepare.
4. Investing

### Breaking Down Optimal Capital Structure

An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
5. Investing

### Evaluating a Company's Capital Structure

Learn to use the composition of debt and equity to evaluate balance sheet strength.

### Capital Structure

Capital structure is the combination of the debt and equity a company uses to finance its long-term operations and growth.
7. Investing

### McDonald's Stock: Capital Structure Analysis (MCD)

Learn about the importance of capital structure, and what equity and debt capitalization measures can tell us about the performance of McDonald's Corporation.
8. Investing

### Apple's \$12 Billion Bond Issue Meant to Boost WACC

Apple, Inc. announced that it would issue \$12 billion in corporate bonds to the public in order to return profits to shareholders via dividends and a share buyback program of equivalent size.
9. Investing

### The Capital Asset Pricing (CAPM) Model: Pros and Cons

CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations.
RELATED TERMS
1. ### Cost Of Capital

The required return necessary to make a capital budgeting project, ...
2. ### Return On New Invested Capital - RONIC

A calculation used, either by a firm or investors, to determine ...

1. A performance metric that is equal to the difference between ...
4. ### Incremental Cost Of Capital

A term used in capital budgeting, the incremental cost of capital ...
5. ### Composite Cost Of Capital

A company's cost to borrow money given the proportional amounts ...
6. ### Traditional Theory Of Capital Structure

The theory that when the Weighted Average Cost of Capital (WACC) ...
Hot Definitions
1. ### Preferred Stock

A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
2. ### Net Profit Margin

Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
3. ### Gross Margin

A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
4. ### Current Ratio

The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
5. ### SEC Form 13F

A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
6. ### Quantitative Easing

An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...