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:

  • common equity,
  • preferred equity,
  • bonds,
  • convertible bonds,
  • other debt,
  • options,
  • warrants, and
  • other liabilities.

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:

  • E is the market value of equity
  • D is the market value of debt issued by the firm
  • V is the market value of all outstanding securities issued by the firm (E+D)
  • re is the cost of equity
  • rd is the cost of debt
  • t is the corporate tax rate

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:

  • P is the market value of preferred equity
  • rp is the cost of preferred equity
  • V equals E+D+P

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:

  • Ci is market value of a component of capital (e.g. common stock, preferred stock, or bonds)
  • ri is the cost of component Ci
  • V is the sum of market value of all components (C1+C2+…+Cn)

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:

  • Know (or calculate) the cost of each source of capital.
  • Know (or calculate) the weight or market value of each source of capital.
  • Multiply the weight or market value of each source of capital by its cost.
  • Add up all components.
  • If you have used weights of each component, the sum is already the WACC.
  • If you have used market value of each component, you need to divide the result by the sum of all market values. The result is the WACC.