A:

Weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds and any other long-term debt. A company has two primary sources of financing - debt and equity - and, in simple terms, WACC is the average cost of raising that money. WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the WACC value:

WACC = * Re + * Rd * (1 – Tc)

Where:

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

When calculating a firm's WACC, the first step is to determine what proportion of a firm is financed by equity and what proportion is financed by debt by entering the appropriate values into the and components of the equation. Next, the proportion of equity () is multiplied by the cost of equity (Re); and the proportion of debt () is multiplied by the cost of debt (Rd).

The debt side of the equation (* Rd) is then multiplied by (1 - Tc) to get the after-tax cost of debt (there is a tax shield associated with interest). The final step is to add the equity side of the equation to the debt side of the equation to determine WACC.

For example, a firm's financial data shows the following:

  • Equity = $8,000
  • Debt = $2,000
  • Re = 12.5%
  • Rd = 6%
  • Tax rate = 30%

To find WACC, enter the values into the equation and solve:

WACC =[( * 0.125)] + [( * 0.06 * (1 - 0.3)]

WACC = 0.1 + .0084 = 0.1084 or 10.84%; the WACC for this firm then is 10.84%.

Because the calculation takes time, most investors use online stock analysis tools to find a company's WACC.

RELATED FAQS

  1. What is the formula for calculating weighted average cost of capital (WACC) in Excel?

    Learn about the weighted average cost of capital (WACC) formula and how it is used to estimate the average cost of raising ...
  2. How do I use the CAPM (capital asset pricing model) to determine the cost of equity?

    Learn about the elements of the capital asset pricing model, and discover how to use this formula to calculate a business' ...
  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 ...
  4. What is the difference between called-up share capital and paid-up share capital?

    Find out about the difference between called-up and paid-up share capital, including an explanation of the four categories ...
RELATED TERMS
  1. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative ...
  2. Nonadmitted Balance

    An item on an insurer’s balance sheet that represents reinsured ...
  3. Best's Capital Adequacy Relativity (BCAR)

    A rating of an insurance company’s balance sheet strength. Best’s ...
  4. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  5. Working Capital

    This ratio indicates whether a company has enough short term ...
  6. Amortization

    1. The paying off of debt in regular installments over a period ...

You May Also Like

Related Articles
  1. Fundamental Analysis

    What is the formula for calculating ...

  2. Fundamental Analysis

    How do I use the CAPM (capital asset ...

  3. Investing

    How do you calculate the proper weights ...

  4. Fundamental Analysis

    How To Decode A Company's Earnings Reports

  5. Investing Basics

    Useful Balance Sheet Metrics

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!