Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital Definition

Weighted Average Cost of Capital, also known by the acronym WACC, is the average cost of capital (financing) of a firm calculated as weighted arithmetic mean of all components of its capital.

Components of a firm’s capital include particularly the following:

Calculating Weighted Average Cost of Capital

WACC with Equity and Debt Only

Calculating WACC for small firms or for companies with simple capital structure is quite straightforward. The two most typical components of a firm’s capital are common equity and debt. Weighted Average Cost of Capital is calculated as:

Weighted Average Cost of Capital formula for equity and debt only

… where:

Multiplying the debt component by (1-t) reflects the fact that interest expense (the cost of debt) qualifies as cost for tax purposes and therefore reduces the firm’s payable tax by rd t and the next cost of debt is rd (t-1).

WACC with Common Equity, Debt, and Preferred Equity

If a company is financed by common stock, preferred stock, and debt, preferred equity also enters the calculation, using the same logic:

Weighted Average Cost of Capital formula for common equity, debt, and preferred equity

… where:

WACC with Multiple Sources of Capital

Big companies often have complex capital structure, which makes the calculation of WACC more complicated. In general, for a company with n different sources of capital, weighted average cost of capital is calculated as:

Weighted Average Cost of Capital formula for multiple sources of capital

… where:

Note: If there is debt as one of the components, the ri in this case already reflects the effect of taxes (1-t).

Weighted Average Cost of Capital Formula

The general formula for WACC with any number of sources of capital is:

Weighted Average Cost of Capital formula for multiple sources of capital

… where the meaning of individual parameters is the same as in the previous formula.

This is in fact nothing more than weighted arithmetic mean:

Weighted average formula

When calculating weighted average cost of capital, you need to take the following steps: