# 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: … 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: … 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: … 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: … 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.