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 is the formula for calculating weighted average cost of capital (WACC)?

Weighted average cost of capital (WACC) is the average after-tax cost of a company's various capital sources used to finance ... Read Answer >>
2. ### 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 (WACC), and why it matters ... Read Answer >>
3. ### 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 >>
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. ### 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 >>
Related Articles

### Explaining Cost Of Capital

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

### Methods used in valuing private companies

There are a few methods for calculating the valuation of a private company. By using financial information from peer groups, we can estimate the valuation of a target firm.
4. Investing

### Evaluating a Company's Capital Structure

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

### DCF Valuation: The Stock Market Sanity Check

Calculate whether the market is paying too much for a particular stock.
6. 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.
7. Investing

### Valuing Firms Using Present Value of Free Cash Flows

When trying to evaluate a company, it always comes down to determining the value of the free cash flows and discounting them to today.
8. Investing

### Cost of Debt

Cost of debt is the rate, expressed as a percentage, that a company pays on its borrowings.
RELATED TERMS
1. ### Weighted Average Cost Of Capital - WACC

The calculation of a firm's cost of capital, in which each source ...
2. ### Capital Funding

Capital funding is the money that lenders and equity holders ...
3. ### Debt Financing

Debt financing occurs when a firm raises money for working capital ...
4. ### Composite Cost Of Capital

Composite cost of capital is a company's cost to finance its ...
5. ### Capital Structure

Capital structure is how a firm funds its operations and growth, ...
6. ### Cost Of Equity

The cost of equity is the rate of return required on an investment ...
Hot Definitions
1. ### Gross Margin

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

Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
3. ### Discount Rate

Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
4. ### Economies of Scale

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
5. ### Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
6. ### Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...