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,
- convertible bonds,
- other debt,
- 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:
- 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:
- 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:
- 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:
… where the meaning of individual parameters is the same as in the previous formula.
This is in fact nothing more than weighted arithmetic mean:
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.