Weighted Average Cost of Capital (WACC) Explained with Formula and Example

The weighted average cost of capital (WACC) represents a firm’s average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. WACC is the average rate a company expects to pay to finance its assets.

The weighted average cost of capital is a common way to determine required rate of return because it expresses, in a single number, the return that both bondholders and shareholders demand in order to provide the company with capital. A firm’s WACC is likely to be higher if its stock is relatively volatile or if its debt is seen as risky because investors will require greater returns.

Understanding WACC

WACC and its formula are useful for analysts, investors, and company management—all of whom use it for different purposes. In corporate finance, determining a company’s cost of capital is vital for a couple of reasons. For instance, WACC is the discount rate that a company uses to estimate its net present value.

WACC is also important when analyzing the potential benefits of taking on projects or acquiring another business. If the company believes that a merger, for instance, will generate a return higher than its cost of capital, it’s likely a good choice for the company. If its management anticipates a return lower than what their own investors are expecting, they’ll want to put their capital to better use.

As the majority of businesses run on borrowed funds, the cost of capital becomes an important parameter in assessing a firm’s potential for net profitability. Weighted average cost of capital measures a company’s cost to borrow money. The WACC formula uses both the company’s debt and equity in its calculation.

In most cases, a lower WACC indicates a healthy business that’s able to attract 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—calculating its cost of capital would be relatively simple. If investors expected a rate of return of 10% in order to purchase shares, the firm’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 outstanding bonds, its cost of debt would be 5%. This is also its cost of capital.

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

Suppose that a company obtained $1,000,000 in debt financing and $4,000,000 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).

Calculating WACC in Excel

The weighted average cost of capital can be calculated in Excel. The biggest challenge is sourcing the correct data to plug into the model. See Investopedia’s notes on how to calculate WACC in Excel.

Explaining the Formula Elements

Cost of equity (Re) 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 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 investments 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 will simply sell off their shares, which leads to a decrease in share price and in the company’s value. The cost of equity, then, is essentially the total return that a company must generate in order 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 firms have to lean on historical data, which can never accurately predict future growth.

Determining the cost of debt (Rd), on the other hand, is a more straightforward process. This is often done by averaging the yield to maturity for a company’s outstanding debt. 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 and then add a relevant spread over risk-free assets (for example, Treasury notes of the same maturity) to approximate the return 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 has saved in taxes. This is why Rd (1 – the corporate tax rate) is used to calculate the after-tax cost of debt.

Who Uses WACC?

Securities analysts may use WACC when assessing the value of investment opportunities. For example, in discounted cash flow analysis, one may apply WACC as the discount rate for future cash flows in order to derive a business’s net present value.

WACC vs. Required Rate of Return (RRR)

The required rate of return (RRR) is the minimum rate an investor will accept for a project or investment. If they expect a smaller return than what they require, they’ll allocate their money elsewhere.

One way to determine the RRR is by using the CAPM, which uses 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 the 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 versus 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 help lend valuable insight into a company, one should always use it along with other metrics when determining whether to invest in a company.

The WACC can be difficult to calculate if you’re not familiar with all the inputs. Higher debt levels mean the investor or company will require higher WACCs. More-complex balance sheets, such as varying types of debt with various interest rates, make it more difficult to calculate WACC. 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.

In addition, the WACC is also not suitable for accessing risky projects because to reflect the higher risk the cost of capital will be higher. Instead, investors may opt to use the adjusted present value (APV), which does not use the WACC.

Example of How to Use WACC

As an example, consider a hypothetical manufacturer called XYZ Brands. Suppose the book value and market value of the company’s debt are $1,000,000, and its market capitalization (or the market value of its equity) is $4,000,000.

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 .08 (0.8 x .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, “1 minus Tc” is equal to 0.75.

In the end, we arrive at a weighted cost of debt of .0075 (0.2 x .05 x 0.75). When that’s added to the weighted cost of equity (.08), we get a WACC of .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 opportunities.