Weighted Average Cost of Capital

WACC is a calculation of a firm’s cost of capital in which each category is proportionally weighted. It is the
average rate that a company is expected to pay to its stakeholders to finance its assets. In simple terms the
minimum return that the firm should earn on the existing asset base so that the investors and lenders are
interested, or they will invest elsewhere.

Basic terminology of the WACC formula is as follows:

WACC = [Cost of Equity * % of Equity] + [Cost of Debt * % of Debt * ( 1 – tax rate)]

Mathematically, it can be expressed as:

WACC = E/ V * Re + D/V *Rd *(1-Tc)

Where

E = Market cap i.e. Market value of the firm’s equity

D = Market value of the firm’s debt

V = total value of the capital or total value of firm’s financing = D + E

E/V = percentage of capital that is equity

D/V = percentage of capital that is debt

Re = cost of equity (required rate of return)

Rd = cost of debt

Tc = Corporate tax rate

Breakup of the formula

Part 1 : Cost of Equity :

The cost of equity is difficult to measure because a company doesn’t pay any interest on this amount. Issuing
stocks is free for a firm as it raises equity capital and pay a cost in the form of dilution of ownership. Also,
each share doesn’t have any specified value. At any point of time the price of share is determined by the
amount the investors are willing to pay to participate in the growth story of the firm. Hence it is only an
anticipated value and not a fixed number.

The best way to measure cost of equity is to quantify this expected value. It is an implied cost or an
opportunity cost of capital. It is the return that shareholders expect in order to compensate for the risk they
undergo when they invest their capital in the equity (stock). We can use Capital Asset Pricing Model (CAPM)
in such a scenario.

Re = Rf + B * ( Rm – Rf)
Rf = Risk free rate. It is the return that can be earned by investing in a risk- less security, for example US
treasury bonds, hence the name risk free. For all financial models 10-year US Treasury is used as risk free
rate.

Rm = Annual return of the market

B = Equity Beta. It is the measure of the stock’s volatility of returns compared to a benchmark index like S&P
500 or NIFTY 50. It is calculated using the historical returns of the stock relative to the benchmark returns. It
provides a view to investors to:

A) Understand the direction of the stock movement compared to market/benchmark

B) The volatility of the stock compared to the volatility of the market.

Part 2: Cost of Debt:

Compared to cost of equity, cost of debt is relatively easy to calculate as it is not an expected value in future
but a predetermined rate that has been agreed on by the firm before issuing any bonds to the investors. We
can use market interest rate or the actual interest rate that the firm has promised to the debt holders. An
example can be a corporate issuing corporate bonds for an interest rate of 8%. Here irrespective of the
prevailing market deposit rates, firm has promised a coupon rate of 8% per annum and principal amount at
maturity to the investors.

You might notice we have an additional factor (1 – Tc) multiplied by the cost of debt in the WACC formula.
This is because there are additional tax implications with these interest expenses.

An extended version of the formula for the companies that have preferred stock is as follows:

WACC = Cost of equity * % Equity + Cost of Debt * % Debt * (1 – tax rate)

+ Cost of preferred stock * % preferred stock.

Example:

Assume a firm Photon limited that needs to raise capital to buy machinery, land for office space and recruit
more staff to conduct day to day business activities. Let’s say that the firm decided that it needs an amount
of $ 1 million for the same. The firm can raise capital through 2 sources – Equity and Debt.

It issues 50,000 shares at $ 10 each and raises $ 500,000 through equity. As investors expect a return of 7 %,
the cost of equity is 7 %.

For the remaining $ 500,000, firm issues 5000 bonds at $ 100 each. The bondholders expect a return of 6%,
hence Photon’s cost of debt will be 6 %.

Additionally, let’s assume the effective tax rate is 35%.

Substituting these values in the WACC formula:

 Notation Refers to Value
E Market value of equity $ 500, 000
D Market value of Debt $ 500, 000
V Total Market Value $1,000,000
Re Cost of Equity 7%
Rd Cost of Debt 6%
Tc tax rate 35%

WACC = [(500,000/1,000,000 * .06) + {(500,000/1,000,000 * .05) * (1 - 0.35)}] = .04625 or ~ 4.62%

Why it matters:

 WACC provides a weighted average of financing which helps in determining how much interest a
company owes for each dollar it finances.
 WACC as a metric is helpful for the Board of directors and business heads to gauge the economic
feasibility of mergers and acquisitions and other inorganic growth opportunities. The lower the firm’s
WACC, the lower it is for the business to fund new ventures.
 Securities analysts, rating agencies and other research analysts evaluate the value of investments and
firm using WACC. It can be used in discounted cash flow analysis to derive the net business value of the
firm. Similarly, it can be used in calculating hurdle rate to derive ROI and economic value calculations.
 Last but not the least, investors can use WACC to determine if an investment is worth pursuing. For
example, if the firm generates a return of 12% but a WACC of 14%, then the firm is losing 2% on every
dollar spent. In that case, investors can drop this investment from their portfolio.