A:

The weighted average cost of capital (WACC) is a financial metric that shows what the total cost of capital (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. Which is more important when estimating cost of capital - debt or equity?

    Learn about the relative costs of debt and equity and how they affect the overall cost of capital, including why debt may ... Read Answer >>
  3. How do you calculate the proper weights of different costs of capital?

    Understand how to calculate the weights of the difference costs of capital and how this calculation is used to determine ... Read Answer >>
  4. 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 >>
  5. Why do I need to unlever beta when making WACC calculations?

    Dive into weighted average cost of capital calculations, and see why firms both unlever and re-lever beta to compare debt ... Read Answer >>
  6. What's the difference between weighted average cost of capital (WACC) and internal ...

    Both weighted average cost of capital (WACC) and internal rate of return (IRR) are great measures for assessing value, but ... 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. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  3. 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
  4. Investing

    How to Calculate Required Rate of Return

    The required rate of return is used by investors and corporations to evaluate investments. Find out how to calculate it.
  5. Investing

    Evaluating a Company's Capital Structure

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

    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

    Lowe's Stock: Capital Structure Analysis (LOW)

    Examine Lowe's Companies' equity capitalization, debt capitalization and enterprise value to analyze trends in the retailer's capital structure.
  8. 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.
RELATED TERMS
  1. Cost Of Capital

    The required return necessary to make a capital budgeting project, ...
  2. Incremental Cost Of Capital

    A term used in capital budgeting, the incremental cost of capital ...
  3. Cost of Debt

    The effective rate that a company pays on its current debt. This ...
  4. Composite Cost Of Capital

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

    The theory that when the Weighted Average Cost of Capital (WACC) ...
  6. Cost Of Equity

    In financial theory, the return that stockholders require for ...
Hot Definitions
  1. Interest Expense

    The cost incurred by an entity for borrowed funds. Interest expense is a non-operating expense shown on the income statement. ...
  2. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  3. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
  4. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
  5. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  6. Backward Integration

    A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it ...
Trading Center