What Is the Weighted Average Cost of Capital (WACC)?

weighted average cost of capital (WACC)

Last Updated May 6, 2024

Running a business requires a solid understanding of basic financial terms and equations. You can use this financial knowledge to better understand how your company operates and ensure you track your finances correctly.

This short article defines and details the formula for the weighted average cost of capital (WACC). This formula may seem confusing at first glance, but it will quickly become apparent after a brief overview and helpful example.

What Is the Weighted Average Cost of Capital (WACC)?

The weighted average cost of capital (WACC) is a formula used by business owners, investors, and analysts to assess a backer’s return on investment from a company.

The majority of companies operate using borrowed capital. Because of this relationship, the cost of capital is an essential criterion for determining the net profitability of a business.

The formula represents the minimum return a company must earn on an existing asset base to satisfy its capital providers.

WACC Formula

The WCAA formula is complex, involving the market value of a company’s equity and debt along with the cost of equity, cost of debt, and corporate tax rate.

With that being said, here is the WACC formula:

WACC = (E/V x Re) + [D/V x Rd x (1 – Tc)]

  • E represents the market value of your company’s equity.
  • D represents the market value of your company’s debt.
  • V = E + D
  • Re represents the cost of equity
  • Rd represents the cost of debt
  • Tc represents your corporate tax rate

Given how elaborate the WACC formula is, let’s dive deeper into how to calculate WACC by moving through the formula step-by-step.

How To Calculate WACC: Step-by-Step

To calculate WACC, start with the first part of the formula (E/V * Re). This represents your capital linked to equity. The second part of the formula [D/V * Rd * (1 – Tc)], determines your capital linked to debt.

1. Determine Market Values for Your Company’s Equity and Debt

To determine your company’s equity [E], multiply your business’s current stock price by the total number of diluted shares outstanding.

You can find your total debt [D] by simply adding up all of your existing liabilities, both short-term and long-term.

2. Find the Sum of Your Company’s Equity Market Value and Debt Market Value

Next, you’ll simply add your debt and equity market values to find the ‘V’ variable in the formula.

3. Find the Actual Cost of Your Company’s Equity

To find the actual cost of equity [RE], it is best to study projected return rates and create an estimate of the cost of issuing stocks and bonds. This estimate is meaningful because the investors’ returns represent a future liability.

4. Find the Actual Cost of Your Company’s Debt

To find the actual cost of debt [RD], you’ll add the total value of all of your loans and other liabilities. Then, divide total interest by your resulting figure to determine cost of debt.

5. Determine Your Corporate Tax Rate

Next, determine your business’s tax rate. This value can vary based on exemptions, deductions, and withholdings. For the example in the following section, a corporate tax rate of 20% is used. It has been converted to decimal for the equation.

6. Apply All Figures to the WACC Formula

By this point, you’ll have calculated all necessary figures to find your weighted average cost of capital. Apply your findings to the following WACC formula:

WACC = (E/V * Re) + [D/V * Rd * (1 – Tc)]

Example of How to Calculate WACC

Imagine a scenario where Company ABC issues stocks and bonds. Company ABC also holds several sources of capital debt. Finally, assume that the company has relatively low investment and capital risks.

Assuming the following information, an analyst can apply it to the equation listed above to get the WACC:

  • E = 50,000
  • Re = 60,000
  • D = 80,000
  • V = 130,000
  • Rd = 90,000
  • Tc = 20%

WACC = [(50,000/130,000) x 60,000] + [(80,000/130,000) x 90,000 x (1 – 0.2)] =

(23,077) + (44,308) = 67,385

In this example, the Company ABC would have a weighted average cost of capital of $67,385. This is a simple example, and there can be other variables, such as preferred and common shares, which are traded at different prices, that need to be accounted for.

What Are the Limitations of WACC in Financial Accounting?

As a company’s capital structure grows more complex, the number of equations necessary to find the WACC will grow. The process can become time-consuming to complete.

Additionally, completing a WACC requires assuming that your company has fixed capital sources. Fixed capital sources are often not the case as market values, tax rates, and costs can regularly fluctuate.

Finally, there are multiple ways to calculate a WACC, which will lead to different results. WACC is also not optimized to calculate riskier investments where the cost of capital is necessarily adjusted to be higher in cost.

In these cases, a business or investor will often utilize an adjusted present value (APV) formula, which provides considerations for variations in debts and equities to provide a reliable calculation.

To optimize your WACC, you should do the following:

  • Perform a risk analysis: A risk analysis will identify any capital costs which are too risky to factor into a WACC so that you can make the appropriate adjustments.
  • Identify all sources of capital: Not including all sources of capital in the WACC formula will create an inaccurate result. Find all sources of capital costs, including issued bonds, loans, and all interest obligations.
  • Establish correct metrics: Be sure that your determinations for market value and the actual costs of equity and debt are accurate. Fluctuations in operations and market values will change the results every time you complete a WACC calculation. Accurate metrics are also necessary any time you are updating a past WACC calculation.
  • Understand appropriate WACC criteria: It is an excellent idea to establish a predetermined set of standards that you must meet before using a WACC. Other criteria can also be outlined for using alternative methods to analyze capital costs.

Bottom Line for Businesses or Investors Using WACC to Calculate Their Cost of Borrowing Money

WACC is a calculation that utilizes a company’s equity and debts to determine its cost of capital. A WACC calculation is useful for analyzing a company’s profitability and how much it spends on business operations.

Investors use WACC to determine the return on their investment in the company. The formula can also be helpful to analysts and business owners for a variety of purposes.