Companies often run their business using the capital they raise through various sources. They include raising money through listing their shares on the stock exchange (equity), or by issuing interest-paying bonds or taking commercial loans (debt). All such capital comes at a cost, and the cost associated with each type varies for each source. The 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. In other words, WACC is the average rate a company expects to pay to finance its assets. Since a company’s financing is largely classified into two types – debt and equity – WACC is the average cost of raising that money which is calculated in proportion to each of the sources. This article explains the calculation method and formula for WACC.
Formula for WACC
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. Mathematically,
In the above formula, E/V represents the proportion of equity-based financing, while D/V represents the proportion of debt-based financing.
WACC formula is the summation of two terms – [(E/V) * Re] and [(D/V) * Rd * (1-Tc)].
The former represents the weighted value of cost of equity-linked capital, while the later represents the weighted value of cost of debt-linked capital.
Weighted Average Cost Of Capital (WACC)
Equity Component of WACC Formula
It is a common misconception that equity capital has no concrete cost that the company must pay after it has listed its shares on the exchange. In reality, there is a cost of equity.
Since shareholders remain invested in expectations of certain returns on their investments in a company, the shareholders' expected rate of return is a cost from the company's perspective. It is because if the company fails to deliver this expected return, shareholders will simply sell off their shares which will lead to a decrease in share price and in the company’s overall valuation. The cost of equity is essentially the amount that a company must spend in order to maintain a share price that will keep its investors satisfied and invested.
One can use the CAPM (capital asset pricing model) to determine the cost of equity. CAPM is a model that established the relationship between the risk and expected return for assets, and is widely followed for the pricing of risky securities like equity, generating expected returns for assets given the associated risk and calculating costs of capital. As per CAPM,
Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)
The risk-free rate can be taken as the annual rate of return available on the risk-free 20-year treasury bonds.
The beta of a stock indicates its risk level relative to the wider stock market (represented by the S&P 500 or the Nasdaq 100 index). A beta value of 1 indicates that the stock is expected to move in tandem with the market. If the Nasdaq index gains 2 percent, so does the individual security. A beta value of +2 indicates the price of security is expected to move at double the rate of change observed in the wider stock market index, and a value of -3 indicates that the price of security will move three times but in opposite direction of the move made by the stock market index. A higher absolute beta indicates a more volatile stock and a lower absolute beta reflects greater stability.
Market rate of return is the average return expected from the price movement of the wider stock market. It is often derived from historical observations, like how much average annual return is generated by the S&P 500 or Nasdaq 100 index over the past 10/20/50 years.
Taking into account the risk-free rate, beta and market rate of return factors, the above formula for cost of equity based on the CAPM model is structured in a way such that it returns the cost of maintaining share valuation at market expected levels.
Let's calculate the cost of equity for retail giant Walmart Inc. (WMT).
As of October 2018, the risk free rate, represented by annual return on 20-year treasury bond was 3.3 percent, beta value for Walmart stood at 0.51, while the average market return, represented by average annualized total return for the S&P 500 index over the past 90 years, is 9.8 percent.
Using these values,
Cost of Equity, Re = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)
= 3.3% + 0.51 * (9.8% - 3.3%) = 6.615%
From the balance sheet, the total shareholder equity for Walmart for the 2018 fiscal year was $77.87 billion (E), and the long term debt stood at $36.83 billion (D). The total for overall capital for Walmart comes to V = (E+D) = $114.7 billion.
The equity-linked cost of capital for Walmart comes to,
[(E/V) * Re] = (77.87/114.7) * 6.615% = 0.0449
Debt Component of WACC Formula
The debt-linked component in the WACC formula, [(D/V) * Rd * (1-Tc)], represent the cost of capital for company issued debt. It accounts for interest a company pays on the issued bonds, or on commercial loans taken from bank.
For instance, the long term Walmart issued bond with a maturity date of August 2037 offers a coupon of 6.5000%, which becomes the Rd value. Since bonds and loans are subject to taxes, there is a provision in the formula to adjust for the corporate tax payments using the factor (1- Tc). The U.S. federal corporate income tax rate is a charged at a flat 21 percent (Tc).
Using the above figures, the debt component comes to,
[(D/V) * Rd * (1-Tc)] = (36.83/114.7) * 6.5% * (1-21%)
Using the above two computed figures, WACC for Walmart comes to
WACC = Equity Component + Debt Component
= 0.0449 + 0.0165
= 0.0614 = 6.14%
On an average, Walmart is paying around 6.14 percent per annum as the cost of overall capital raised via a combination of debt and equity.
While the above example is a simple illustration to calculate WACC, one may need to compute it in a more elaborate manner if the company is having multiple forms of capital with each having a different cost. For instance, if the preferred shares are trading at a different price than common shares, if the company issued bonds of varying maturity are offering different returns, or if the company has a (combination of) commercial loan(s) at different interest rate(s), then each such component needs to be accounted for separately and added together in proportion of the capital raised.
Uses of WACC
As majority of businesses run on borrowed funds, the cost of capital becomes an important parameter in assessing a firm’s potential of net profitability. Analysts and investors use WACC to assess an investor’s returns on an investment in a company. For example, a company has generated 12 percent returns over a given period and had a WACC of 7 percent, it means that it is yielding net 5 percent returns on every dollar the company invests.