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. Rather than being dictated by a company's management, WACC is determined by external market participants and signals the minimum return that a corporation would take in on an existing asset base, in its effort to capture the interest of investors, creditors, and other capital providers. Companies that don't demonstrate an inviting WACC number may lose their funding sources, who are likely to deploy their capital elsewhere.
- The weighted average cost of capital (WACC) is a financial metric that reveals what the total cost of capital is for a firm.
- The cost of capital is the interest rate paid on funds used for financing operations.
- Companies fund operations either through debt or equity, where each source has its own associated cost.
- Companies without an inviting WACC number risk losing their funding sources, who are likely to bring their dollars elsewhere.
All companies must finance their operations, and this funding either comes from debt, equity, or a combination of the two. Each source has a certain cost associated with it. And when analyzing different financing options, calculating the WACC provides the company with its financing cost, which is then used to discount the project or business in a valuation model.
WACC is calculated with the following equation:
WACC = wD*rD *(1-t) + wP*rP + wE*rE
- w = the respective weight of debt, preferred stock/equity, and equity in the total capital structure
- t = tax rate
- D = cost of debt
- P = cost of preferred stock/equity
- E = cost of equity
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 as follows: debt, preferred equity, and finally, equity.
Corporations rely on WACC figures to suss out which to see projects are worthwhile.
Calculating WACC in Excel
Calculating WACC is a relatively straightforward exercise. As with most financial modeling, the most challenging aspect is obtaining the correct data with which to plug into the model.
The following illustration exemplifies the data needed to estimate a company's WACC:
The after-tax cost of debt may be sourced from the debt disclosures contained in a company's filings. As mentioned, the cost of equity is calculated with CAPM. Total capital is calculated by adding the debt to the market value of the equity.