Last Updated on April 13, 2022
Running a business requires a solid understanding of basic financial terms and equations. You can use this financial knowledge to understand better 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.
Weighted Average Cost of Capital (WACC) and Why It’s Used
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.
What Is the Formula for WACC?
The WCAA formula can be calculated as (E/V * Re) + [D/V * Rd * (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
How To Calculate and Use WACC
It would be best if you determined all of your relevant values before you can calculate your company’s WACC.
- Determine market values for the company’s equity and debt.
- It is necessary to understand how your company manages these costs to continue generating profits.
- Find the actual costs of the company’s equity and debt.
- To find the actual cost of debt, evaluate the company’s assets and liabilities. Then determine the actual cost of covering the capital debts.
- To find the actual cost of equity, 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.
- Combine the market values of debt and equity.
- Combining the debt and equity market values will give you the V variable.
- Determine your corporate tax rate.
- Find the tax rate for your business. This value can vary based on exemptions, deductions, and withholdings. For the example in the next section, a corporate tax rate of 20% is used. It has been converted to decimal for the equation.
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.
You multiply each side of the formula by its relative weight and then add the two products to find the value.
Here is an example of how to calculate a WACC:
The hypothetical company used for this example issues stocks and bonds. It also holds several sources of capital debt. Finally, it is assumed that the company has relatively low investment and capital risks.
Assuming the following information, the company’s 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 hypothetical company 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.
What Is the 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.