What is the 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 types of equities according to their proportion in the corporate structure. 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.
How the Weighted Average Cost of Equity (WACE) Works
The weighted average cost of equity (WACE) is essentially the same as the cost of equity that relates to the Capital Asset Pricing Model (CAPM). Rather than simply averaging out the cost of equity, a weighting is applied that reflects the mix of that equity type in the company at the time. If the cost of equity was averaged without being weighted, outliers in the cost of equity could cause an overstatement or understatement of the cost.
- The weighted average cost of equity (WACE) measures the cost of equity proportionally for a company rather than simply averaging the overall figures.
- With the weighted average cost of equity, the cost of a particular equity type is multiplied by the percentage of the capital structure it represents.
- The cost of equity used in most formulas is usually a weighted average cost of equity, even if this is not explicitly stated.
Calculating the Weighted Average Cost of Equity (WACE)
Calculating the weighted average cost of equity isn't as straightforward as calculating the cost of debt. First, you must calculate the cost of new common stock, the cost of preferred stock, and the cost of retained earnings separately. The most common way to do this is the CAPM formula:
Cost of equity = Risk free rate of return + [beta x (market rate of return – risk-free rate of return)]
Generally speaking, the cost of equity for common stock, preferred stock, and retained earnings will usually be within a tight range. For this example, let us assume the cost of common stock, preferred stock, and retained earnings are 14%, 12% and 11%, 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 = (.14 x .50) + (.12 x .25) + (.11 x .25) = 0.1275 or 12.8%
Simply averaging the cost of equity across categories in the example above would have yielded a cost of equity of 12.3%. That said, averaging is rarely done as the weighted average cost of equity is usually used as part of the larger calculation of a company's weighted average cost of capital (WACC).
Why the Weighted Average Cost of Equity (WACE) 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 can also be coupled with other indicators, such as the after-tax cost of debt to form an assessment. As mentioned, the weighted average cost of equity is commonly combined with the weighted average cost of debt to calculated a firm's weighted average cost of capital (WACC).
As part of the WACC, the WACE is 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. As a stand-alone metric, the weighted average cost of equity tends to temper a company's issuance of new stock if it is attempting to raise more capital. Debt in the form of bonds tends to be a cheaper way of raising capital for most companies, and is easier for investors to calculate the capital costs of debt when doing balance sheet analysis.