Weighted Average Cost of Capital
When analyzing different financing options, companies need to look at how much it will cost to fund operations. There are two different forms of capital – debt and equity – and each has a cost associated with it. Shareholders demand returns on their investments. Debt, whether through bank loans or bonds, requires the payment of interest. Companies use a formula called the weighted to determine the average cost of raising capital through both sources.
Weighted Average Cost of Capital Defined
WACC = (Equity / Total Capital) * Cost of Equity + (Debt / Total Capital) * Cost of Debt * (1 – Tax Rate)
The WACC takes into account both the sources of capital and the proportion of total capital each source represents. The weights are simply the ratios of debt and equity to the total amount of capital.
Cost of capital is the amount of money that must be paid for the privilege of accessing funds.
Cost of capital= money that must be paid for the privilege of accessing funds
For debt capital, this can be thought of as the interest rate. For equity funds, the cost of capital is more complicated.
Cost of debt capital= the interest rate
-Because payments on debt interest are tax-deductible, the cost of debt capital is discounted accordingly.
-In WACC calculation, the cost of debt is incorporated after tax basis.
Many in corporate accounting calculate the cost of equity (COE) by using the capital asset pricing model (CAPM).
Capital asset pricing model (CAPM) – This formula multiplies the;
-stock’s beta value by the market’s risk premium or
-the market’s return rate minus the risk-free rate) and then adds the market’s risk-free rate.
The firm’s cost of equity is best (or, at least, most easily) calculated using the CAPM (Capital Asset Pricing Model).
Cost of Equity rE = rf + β(rM – rf) where…
rf = the ‘Risk Free’ rate of return
β = the firm’s ‘Beta’; the correlation between the firm’s returns and the market
rM = the historical “Market” return
Equity refers only to common shareholder equity.
If a company raises capital through the sale of preferred shares, the following is added to the above formula:
+ (Preferred Share Equity / Total Capital) * Cost of Preferred Share Equity.
The cost of preferred share equity is the value of preferred dividends divided by the price per share.
Cost of preferred share= preferred dividends divided by the price per share
Calculating WACC in Excel
To calculate WACC in Microsoft Excel, first enter the value of equity capital into cell A1. To calculate the COE, enter the market risk-free rate, beta and market rate of return into cells B1 through B3. In cell B4, enter the formula = B1 + B2 * (B3 – B1) to render the COE.
Enter the value of debt capital, the cost of debt and tax rate into cells C1, D1 and E1, respectively.
In cell F1, enter the formula “=A1+C1” to render the total capital.
Finally, in cell G1, enter the formula “= (A1/F1) * B4 + (C1/F1) * D1 * (1-E1) to calculate the WACC.
A Brief Example of WACC
Assume a new business is looking to raise funds through both debt and equity financing. Under one financing plan, the company will sell 10,000 shares of stock at $10 per share and take out a $50,000 loan with a 6% interest rate. The COE is calculated to be 4%. Assume the corporate tax rate is 35% and no preferred shares are issued. Using Excel, the business’s accountant calculates the WACC for this financing plan to be ($100,000 / $150,000) * 0.04 + ($50,000 / $150,000) * 0.06 * (1 – 0.35), or 3.97%.