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. 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 >>
  2. 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 >>
  3. 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 >>
  4. 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 >>
  5. 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 >>
  6. 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 >>
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. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  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

    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.
  6. 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.
  7. 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.
  8. Investing

    Understanding Verizon's Capital Structure (VZ)

    Verizon has a highly leveraged capital structure, and this debt capitalization and the company's equity have affected its enterprise value.
RELATED TERMS
  1. Cost Of Capital

    The required return necessary to make a capital budgeting project, ...
  2. Capital Funding

    Capital funding is the money that lenders and equity holders ...
  3. Return On New Invested Capital - RONIC

    A calculation used, either by a firm or investors, to determine ...
  4. Cost of Debt

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

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

    A mix of a company's long-term debt, specific short-term debt, ...
Hot Definitions
  1. IRR Rule

    A measure for evaluating whether to proceed with a project or investment. The IRR rule states that if the internal rate of ...
  2. Short Covering

    Short covering is buying back borrowed securities in order to close an open short position.
  3. Covariance

    A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns ...
  4. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  5. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  6. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
Trading Center