Figure 1: Capital Structure Weight vs. Contribution to WACC
What is Calculation Weighted Average Cost of Capital?
The calculation weighted average cost of capital (WACC) is a financial metric that represents the average rate a company expects to pay to finance its assets. WACC is calculated by averaging the costs of all sources of capital, including common stock, preferred stock, bonds, and other long-term debt. Each source is weighted according to its proportion in the company's capital structure.
Investors and analysts use the calculation weighted average cost of capital to assess the investment value of a company. If a company's Return on Invested Capital (ROIC) exceeds its WACC, it is creating value for shareholders. Conversely, if the ROIC is lower than the WACC, the company is destroying value.
Corporate finance professionals often use this metric as the discount rate for future cash flows in Discounted Cash Flow (DCF) analyses to derive the net present value of a business or project.
Calculation Weighted Average Cost of Capital Formula
The mathematical foundation for the calculation weighted average cost of capital involves summing the cost of equity and the after-tax cost of debt, weighted by their respective market values.
WACC = (E/V × Re) + [(D/V × Rd) × (1 – t)]
Below is a detailed breakdown of each variable used in the calculation weighted average cost of capital:
WACC Formula Variables
Variable
Meaning
Unit
Typical Range
E
Market Value of Equity
Currency ($)
Positive Value
D
Market Value of Debt
Currency ($)
Positive Value
V
Total Value (E + D)
Currency ($)
Positive Value
Re
Cost of Equity
Percentage (%)
6% – 15%
Rd
Cost of Debt
Percentage (%)
2% – 10%
t
Corporate Tax Rate
Percentage (%)
15% – 30%
Practical Examples of WACC Calculation
Example 1: Tech Startup
Consider a technology firm with high growth potential but significant risk. The company has a capital structure dominated by equity.
A utility company typically has stable cash flows and can support more debt.
Equity (E): $50,000,000
Debt (D): $50,000,000
Cost of Equity (Re): 7% (Lower risk)
Cost of Debt (Rd): 4%
Tax Rate (t): 25%
Calculation Weighted Average Cost of Capital:
Weight of Equity = 50%
Weight of Debt = 50%
After-Tax Cost of Debt = 4% × (1 – 0.25) = 3.0% WACC = (0.50 × 7%) + (0.50 × 3%) = 3.5% + 1.5% = 5.00%
How to Use This WACC Calculator
Enter Market Value of Equity: Input the total market capitalization of the company. Avoid using book value if market value is available.
Enter Market Value of Debt: Input the total interest-bearing debt. This includes short-term and long-term loans and bonds.
Input Cost of Equity: This is often derived using the Capital Asset Pricing Model (CAPM). It reflects the return shareholders require.
Input Cost of Debt: Enter the pre-tax interest rate the company pays on its debt.
Adjust Tax Rate: Enter the effective marginal corporate tax rate to calculate the tax shield benefit of debt.
Analyze Results: Review the calculated WACC displayed in the green box. Use the "Copy Results" button to save the data for your reports.
Key Factors That Affect Calculation Weighted Average Cost of Capital
Several internal and external factors influence the outcome of a calculation weighted average cost of capital.
1. Interest Rates
The risk-free rate is a core component of both the cost of debt and the cost of equity. When central banks raise interest rates, the cost of debt increases, and the expected return on equity typically rises, leading to a higher WACC.
2. Tax Rates
Interest payments on debt are generally tax-deductible, creating a "tax shield." A higher corporate tax rate lowers the after-tax cost of debt, which effectively reduces the overall WACC.
3. Capital Structure
Changing the ratio of debt to equity alters the weights in the calculation weighted average cost of capital. Debt is usually cheaper than equity, so increasing debt can lower WACC up to a point. However, excessive debt increases bankruptcy risk, which eventually drives up the cost of both debt and equity.
4. Market Risk Premium
The premium investors demand for holding risky assets (stocks) over risk-free assets affects the cost of equity. During economic uncertainty, the market risk premium rises, increasing the WACC.
5. Company Beta
Beta measures a stock's volatility relative to the market. A high beta implies higher risk, requiring a higher cost of equity, thus increasing the calculation weighted average cost of capital.
6. Credit Rating
A company's credit rating directly impacts its cost of debt. A downgrade by rating agencies leads to higher interest rates on bonds and loans, increasing the WACC.
Frequently Asked Questions (FAQ)
Why is the cost of debt multiplied by (1 – tax rate)?
This adjustment accounts for the tax deductibility of interest payments. Governments essentially subsidize debt financing, making the effective cost of debt lower than the nominal interest rate.
Should I use Book Value or Market Value?
For an accurate calculation weighted average cost of capital, you should always use market values for equity and debt. Market values reflect the current economic reality and the price investors are willing to pay today.
What is a "good" WACC number?
There is no universal "good" number. A lower WACC is generally better as it implies cheaper funding. However, WACC varies by industry. Technology firms often have higher WACCs (10%+) compared to utilities (4-6%).
Can WACC be used for all projects?
Not necessarily. The company-wide WACC represents the average risk of the entire firm. If a specific project is significantly riskier or safer than the company's core business, the WACC should be adjusted accordingly.
How often should I recalculate WACC?
WACC should be recalculated whenever there are significant changes in interest rates, the company's stock price, debt levels, or corporate tax laws.
Does preferred stock affect WACC?
Yes. If a company has preferred stock, it should be added as a third component in the formula: (Weight of Preferred × Cost of Preferred). Preferred dividends are not tax-deductible.
What happens if WACC is higher than ROIC?
If WACC is higher than Return on Invested Capital (ROIC), the company is destroying shareholder value. It is paying more to capital providers than it is earning from its investments.
Is WACC the same as the discount rate?
WACC is the most common discount rate used in Discounted Cash Flow (DCF) analysis for enterprise valuation. However, for equity valuation specifically, the Cost of Equity is used as the discount rate.