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

What Is Weighted Average Cost of Capital (WACC)?

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

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

Understanding WACC

Calculating a company's WACC is useful for investors and stock analysts, as well company management, although they may use it for different purposes.

In corporate finance, determining a company's cost of capital can be important for a couple of 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, then it might want to put its capital to better use.

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. By contrast, a higher WACC usually coincides with businesses that are seen as riskier and need to compensate investors with higher returns. 

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.

However many companies use both debt and equity financing in various proportions, which is where WACC comes in.

WACC Formula and Calculation

$\begin{aligned} &\text{WACC} = \left ( \frac{ E }{ V} \times Re \right ) + \left ( \frac{ D }{ V} \times Rd \times ( 1 - Tc ) \right ) \\ &\textbf{where:} \\ &E = \text{Market value of the firm's equity} \\ &D = \text{Market value of the firm's debt} \\ &V = E + D \\ &Re = \text{Cost of equity} \\ &Rd = \text{Cost of debt} \\ &Tc = \text{Corporate tax rate} \\ \end{aligned}$​WACC=(VE​×Re)+(VD​×Rd×(1−Tc))where:E=Market value of the firm’s equityD=Market value of the firm’s debtV=E+DRe=Cost of equityRd=Cost of debtTc=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 represents the proportion of equity-based financing, while D/V represents the proportion of debt-based financing. The WACC formula thus involves the summation of two terms:

$\left ( \frac{ E }{ V} \times Re \right )$(VE​×Re)

$\left ( \frac{ D }{ V} \times Rd \times ( 1 - Tc ) \right )$(VD​×Rd×(1−Tc))

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. E/V would equal 0.8 ($4,000,000 ÷ $5,000,000 of total capital) and D/V would equal 0.2 ($1,000,000 ÷ $5,000,000 of total capital). 

Explaining the Formula Elements

Cost of equity (Re in the formula) can be a bit tricky to calculate because share capital does not technically have an explicit value. When companies reimburse bondholders, the amount they pay has a predetermined interest rate. On the other hand, equity has no concrete price that the company must pay. As a result, companies have to estimate the cost of equity—in other words, the rate of return that investors demand based on the expected volatility of the stock.

Because shareholders will expect to receive a certain return on their investment in a company, the equity holders' required rate of return is a cost from the company's perspective; if the company fails to deliver this expected return, shareholders may simply sell their shares, which can lead to a decrease in both share price and the company's value. The cost of equity, then, is essentially the total return that a company must generate to maintain a share price that will satisfy its investors.

Companies typically use the capital asset pricing model (CAPM) to arrive at the cost of equity (in CAPM, it's called the expected return of investment). Again, this is not an exact calculation because companies have to lean on historical data, which can never accurately predict future growth.

Determining cost of debt (Rd in the formula), on the other hand, is a more straightforward process. This is often done by averaging the yield to maturity for a company's outstanding debts. This method is easier if you're looking at a publicly traded company that has to report its debt obligations.

For privately owned companies, one can look at the company's credit rating from firms such as Moody's and S&P Global and then add a relevant spread over risk-free assets (for example, Treasury bonds of the same maturity) to approximate the return that investors would demand.

Businesses are able to deduct interest expenses from their taxes. Because of this, the net cost of a company's debt is the amount of interest it is paying minus the amount it was able to deduct on its taxes. This is why Rd x (1 - the corporate tax rate) is used to calculate the after-tax cost of debt.

WACC vs. Required Rate of Return (RRR)

The required rate of return is the minimum rate that an investor will accept. If they expect a smaller return than they require, they'll put their money elsewhere.

One way to determine the RRR is by using the CAPM, which looks at a stock's volatility relative to the broader market (its beta) to estimate the return that stockholders will require.

Another method for identifying the RRR is by calculating WACC. The advantage of using WACC is that it takes the company's capital structure into account—that is, how much it leans on debt financing vs. equity.

Limitations of WACC

The WACC formula seems easier to calculate than it really is. Because certain elements of the formula, such as the cost of equity, are not consistent values, various parties may report them differently for different reasons. As such, although WACC can often offer valuable insight into a company, one should always use it along with other metrics in deciding whether to invest.

More complex balance sheets, such as for companies using multiple types of debt with various interest rates, make it more difficult to calculate WACC. In addition, there are many inputs to calculating WACC—such as interest rates and tax rates—all of which can be affected by market and economic conditions.

Example of How to Use WACC

Consider a hypothetical manufacturer called XYZ Brands. Suppose the market value of the company's debt is $1 million, and its market capitalization (or the market value of its equity) is $4 million. 

Let's further assume that XYZ's cost of equity—the minimum return that shareholders demand—is 10%. Here, E/V would equal 0.8 ($4,000,000 of equity value divided by $5,000,000 of total financing). Therefore, the weighted cost of equity would be 0.08 (0.8 × 0.10). This is the first half of the WACC equation.

Now we have to figure out XYZ's weighted cost of debt. To do this, we need to determine D/V; in this case, that's 0.2 ($1,000,000 in debt divided by $5,000,000 in total capital). Next, we would multiply that figure by the company's cost of debt, which we'll say is 5%. Last, we multiply the product of those two numbers by 1 minus the tax rate. So if the tax rate is 0.25, then "1 minus Tc" is equal to 0.75. 

In the end, we arrive at a weighted cost of debt of 0.0075 (0.2 × 0.05 × 0.75). When that's added to the weighted cost of equity (0.08), we get a WACC of 0.0875, or 8.75% (0.08 weighted cost of equity + 0.0075 weighted cost of debt).

That represents XYZ's average cost to attract investors and the return that they're going to expect, given the company's financial strength and risk compared with other investment opportunities. 

The Bottom Line

Weighted average cost of capital (WACC) is a useful measure for both investors and company executives. However, it can be difficult to compute with accuracy and usually should not be relied on all by itself.