Weighted Average Cost of Capital (WACC): Definition and Formula

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What Is Weighted Average Cost of Capital (WACC)?

Weighted average cost of capital (WACC) is a company's average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. It represents the average rate that a company expects to pay to finance its business.

WACC is a common way to determine the required rate of return (RRR) because it expresses, in a single number, the return that bondholders and shareholders demand in return for providing the company with capital. A company's WACC is likely to be higher if its stock is relatively volatile or if its debt is considered risky because investors will want greater returns to compensate them for the level of risk.

Key Takeaways

• Weighted average cost of capital (WACC) represents a company's cost of capital, with each category of capital (debt and equity) proportionately weighted.
• WACC can be calculated by multiplying the cost of each capital source by its relevant weight in terms of market value, then adding the results together to determine the total.
• WACC is commonly used as a hurdle rate against which companies and investors can gauge the desirability of a given project or acquisition.
• WACC is also used as the discount rate for future cash flows in discounted cash flow analysis.

Understanding WACC

Calculating a company's WACC is useful for investors and stock analysts, as well company management. Each group will use WACC for different purposes.

In corporate finance, determining a company's cost of capital can be important for several reasons. For instance, WACC can be used as the discount rate for estimating the net present value of a project or acquisition.

If the company believes that a merger, for example, will generate a return higher than its cost of capital, then it's likely a good choice for the company. However, if it anticipates a return lower than its investors are expecting, there might be better uses for that capital.

To investors, WACC is an important tool in assessing a company's potential for profitability. In most cases, a lower WACC indicates a healthy business that's able to attract money from investors at a lower cost. A higher WACC usually coincides with businesses that are seen as riskier and need to compensate investors with higher returns to offset the level of volatility.

If a company only obtains financing through one source—say, common stock—then calculating its cost of capital would be relatively simple. If investors expected a rate of return (RoR) of 10% on their shares, the company's cost of capital would be the same as its cost of equity: 10%.

The same would be true if the company only used debt financing. For example, if the company paid an average yield of 5% on its bonds, its cost of debt would be 5%. This is also its cost of capital because all the capital is debt.

However, many companies use both debt and equity financing in various proportions. This is where the calculation for WACC becomes valuable.

WACC Formula and Calculation

WACC is found by determining the proportions of debt and equity financing that a company uses to determine the total cost of capital. The equation is:

WACC = ( E V × R e ) + ( D V × R d × ( 1 − T c ) ) where: E = Market value of the firm’s equity D = Market value of the firm’s debt V = E + D R e = Cost of equity R d = Cost of debt T c = Corporate tax rate \begin &\text = \left ( \frac< E > < V>\times Re \right ) + \left ( \frac< D > < V>\times Rd \times ( 1 - Tc ) \right ) \\ &\textbf \\ &E = \text \\ &D = \text \\ &V = E + D \\ &Re = \text \\ &Rd = \text \\ &Tc = \text \\ \end ​ WACC = ( V E ​ × R e ) + ( V D ​ × R d × ( 1 − T c ) ) where: E = Market value of the firm’s equity D = Market value of the firm’s debt V = E + D R e = Cost of equity R d = Cost of debt T c = Corporate tax rate ​

WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight and then adding those results together. In the above formula, E/V (equity over total financing) represents the proportion of equity-based financing, while D/V (debt over total financing) represents the proportion of debt-based financing. The WACC formula thus involves the summation of two terms:

( E V × R e ) \left ( \frac< E > < V>\times Re \right ) ( V E ​ × R e )

( D V × R d × ( 1 − T c ) ) \left ( \frac< D > < V>\times Rd \times ( 1 - Tc ) \right ) ( V D ​ × R d × ( 1 − T c ) )

The former represents the weighted value of equity capital, while the latter represents the weighted value of debt capital.

Suppose that a company obtained $1 million in debt financing and $4 million in equity financing by selling common shares. The total capital would be $5 million (debt plus equity), so tose proportions would be:

E/V = $4,000,000 / $5,000,000 = 0.8

D/V = $1,000,000 / $5,000,000 = 0.2

You can double check that the proportions are correct because 0.8 + 0.2 = 1.0.