DEFINITION of Weighted Average Cost of Equity (WACE)
Weighted average cost of equity (WACE) is a way to calculate the cost of a company's equity that gives different weight to different aspects of the equities. Instead of lumping retained earnings, common stock, and preferred stock together, WACE provides a more accurate idea of a company’s total cost of equity. Determining an accurate cost of equity for a firm is integral for the firm to be able to calculate its cost of capital.
In turn, an accurate measure of the cost of capital is essential when a firm is trying to decide if a future project will be profitable or not.
BREAKING DOWN Weighted Average Cost of Equity (WACE)
Here is an example of how to calculate the WACE:
- First, calculate the cost of new common stock, the cost of preferred stock and the cost of retained earnings. Let us assume we have already done this and the cost of common stock, preferred stock and retained earnings are 24%, 10% and 20%, respectively.
- Now, calculate the portion of total equity that is occupied by each form of equity. Again, let us assume this is 50%, 25% and 25%, for common stock, preferred stock and retained earnings, respectively.
- Finally, multiply the cost of each form of equity by its respective portion of total equity and sum of the values, which results in the WACE. Our example results in a WACE of 19.5%.
WACE = (.24*.50) + (.10*.25) + (.20*.25) = 0.195 or 19.5%
Why the Weighted Average Cost of Equity Matters
Potential buyers who are considering acquiring a company might use the weighted average cost of equity to help them assign a value to the future cash flows of the target company. The results of this formula might be coupled with other indicators, such as the after-tax cost of debt to form an assessment. These results, in combination, are used to determine the weighted average cost of capital.
Furthermore, the WACE calculation can be used within the company to better assess how its campaigns and capital-intensive projects translate it into the overall return on earnings for the shareholders. After taking such an assessment, it is possible that the management may receive a directive from its board of directors to adopt new approaches that would improve the results, and free up more capital. This might also temper the company’s issuance of new stock if it is attempting to raise more capital, especially if the introduction of such a plan would negatively affect results.