What is WACC?
The weighted average cost of capital (WACC) represents the cost of securing capital. It’s a formula for weighted average cost of capital that measures a business’s cost to borrow money using a calculation of all the business’s sources of capital. This includes bonds, common or preferred stock and debt.
Most companies must raise capital by selling shares or equity, issuing bonds or securing commercial loans, but each method comes at a cost to the business. WACC is the after-tax cost of these capital sources. Business’ capital is mainly generated as either debt or equity, so WACC calculates the proportion of financing acquired through each source. This results in a single figure expression representing the average cost of raising financing.
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Why is WACC important?
WACC can be used both internally and externally. Businesses and financial analysts can use the WACC ratio to assess the benefits of certain business opportunities, such as business expansions or new projects. If analysis suggests the opportunity will likely generate a higher return than the cost of its capital, it will affirm the business’s choice to pursue the opportunity.
WACC is important when securing capital for your business and encouraging current investors to keep their financial contributions with the company. So, WACC is an investment tool that investors can use to evaluate whether your business is a good investment opportunity. In investors’ eyes, WACC represents the minimum rate of return for a company to produce value for its investors.
Related: Finding Investors: What Entrepreneurs Should Know
Higher WACC ratios generally indicate that a business is a riskier investment, while a lower WACC tends to correlate with more stable business investments. With a good WACC, an investor can feel secure in their investment and satisfied with the rate at which they’ll see a return.
Read more: Locating an Investor: Five Steps for Your Business
What is the WACC formula, and how is it calculated?
The WACC formula is:
WACC = (E/V x Re) + (D/V x Rd x (1-Tc))
How to calculate WACC:
There are two major parts to the WACC formula. WACC is calculated by multiplying capital sources, debt and equity, by its relevant weight, then adding the values together. The first half of the formula represents the weighted value of equity capital (E/V), while the second part of the formula represents the weighted value of debt capital (D/V). The final value is the WACC ratio expression.
If you or a financial manager are calculating the WACC for your business, it’s important to understand what each element of the formula represents. Here is a breakdown of the WACC formula:
- E: The market value of the company’s equity
- D: The market value of the business’s debt
- V: The total of the company’s equities and debts (E + D), or the total market value of the firm’s financing
- Re: The cost of equity
- Rd: The cost of debt
- Tc: The current corporate tax rate
To ensure you include the correct figures for each element of the formula, you’ll need to know the difference between Re (cost of equity) and Rd (cost of debt). Re is the amount your company must spend to keep the stock price at an amount that’s still enticing for investors. When someone invests in your business, they’re expecting a good return on their investment later. If the share price shows that it will decrease to an undesirable amount, the investors can sell their stocks, decreasing your company’s overall value.
Rd is the amount of interest your business pays on its debt, minus the amount it doesn’t have to pay in taxes, thanks to the tax-deductible benefit on interest payments. That’s why there is a 1 in the formula.
Example of how to find WACC
Consider a business with $500,000 in debt financing and $1,500,000 in equity financing. In this case, the E/V value is 0.75 ($1,500,000 / $2,000,000), and the D/V value would be 0.25 ($500,000 / $2,000,000).
If the business’s cost of debt is 5%, we multiply that with D/V. The product of that calculation is multiplied by (1 + tax rate). If the tax rate is 0.3, then that value is 0.7. Multiplying these values together results in 0.00875. Added to the weighted cost of equity (0.75 x 0.1 = 0.075), we arrive at the value of 8.38%. This represents the business’s average cost.
FAQs about WACC
The most frequently asked questions about WACC and cost of debt WACC are:
What are the limitations of WACC?
The main limitation of WACC is that equity and debt values aren’t consistent values, which means that the formula is complex to report and manage over time. Capital structures change regularly, so WACC should be combined with other metrics to provide insight into investment and business opportunities.
What is a good WACC?
Investors look for a WACC that’s more than the business’s return. This is because a higher WACC ratio indicates the rate at which a business can provide value to its investors. A lower WACC indicates that the company is losing value.
What is CAPM vs. WACC?
WACC refers to the formula used to calculate the firm’s cost of capital, which includes the cost of both equity and debt. CAPM or cost of equity is part of the WACC formula used to calculate the cost of equity. This is the rate of return that businesses pay to equity investors.
