## 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)
- r
_{e}is the cost of equity - r
_{d}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 r_{d} t and the next cost of debt is r_{d} (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
- r
_{p}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:

- C
_{i}is market value of a component of capital (e.g. common stock, preferred stock, or bonds) - r
_{i}is the cost of component C_{i} - V is the sum of market value of all components (C
_{1}+C_{2}+…+C_{n})

Note: If there is debt as one of the components, the r_{i} 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.