Definition
The financial investing term weighted average cost of capital is used to describe the average cost of financing the capital investments of a company. The weighted average cost of capital calculation takes the percentage of financing derived from each source of funds, and multiplies it by the opportunity cost.
Calculation
Weighted Average Cost of Capital = (S1 x W1) + (S2 x W2) + (S3 x W3)...
Where:
Sn = the opportunity cost associated with each of the various sources of capital financing, including common and preferred stock as well as debt.
Wn = the percentage of the company's total financing derived from each source.
Explanation
Generally, the assets of a company are financed through equity or debt, which includes common stocks as well as bonds. In the case of regulated utilities, preferred stock may also play a role in financing assets. A company's weighted average cost of capital, or WACC, is calculated by taking the cost of each source of financing and multiplying it by its share of the total financing of the company.
When evaluating the economic feasibility of an investment, a company will typically use its WACC to discount future cash flows. For example, if a business segment were to propose a new capital project, the company's WACC would be used as the discount rate when determining the present value of the project's future cash flows. If the net present value of the project is greater than zero, then the benefits associated with the project would be greater than its financing cost.
The cost and weight of each component is determined as outlined in the following sections.
Equity
The total value of equity issued by a company is the number of shares outstanding multiplied by the price per share as shown below. This approach can be applied to common stock as well as any preferred shares issued to the marketplace.
Market Value of Equity = Price per Share x Shares Outstanding
The cost of equity is found by taking the risk-free rate and multiplying it by the stock's beta and adding to this value a risk premium. The risk premium is the expected rate of return for the stock, or capital project, in excess of the risk-free interest rate. This is sometimes referred to as an equity premium.
Cost of Equity = (Risk Free Rate x Stock Beta) + Risk Premium
Debt
The formula for finding the value of debt is fairly complex, requiring knowledge of the book value of the company's debt, the annual interest expense, the average maturity of the company's debt, as well as its pre-tax cost. A formula for determining the value of debt appears below: Market Value of Debt = E x (1 - (1 + P)-M) / P + B / (1+P)M
Where:
B = Book Value of Debt ($)
E = Interest Expense on Debt ($)
M = Average Maturity of Debt (Years)
P = Pre-tax Cost of Debt (% / Year)
The cost of debt is found by taking its pre-tax cost and multiplying it by 1 minus the company's tax rate as shown below:
Cost of Debt = P x (1 - T)
Where:
P = Pre-tax Cost of Debt (% / Year)
T = Effective Tax Rate (%)
Example
Company A currently has 250,000,000 shares of common stock outstanding. The current market price of Company A's shares is $23.50, and the stock's beta is 1.05. The current risk-free rate of interest is 4.50%, and the risk premium for this project is 4.00%. The book value of Company A's debt is $5,000,000,000. The income statement indicates interest expense of $600,000,000, and an average maturity of ten years. Company A's pretax cost of debt is 6.50% per year and its tax rate is 40%.
The solution to the above example can be found using our Weighted Average Cost of Capital Calculator, which uses the formulas outlined in the above sections.
Related Terms
beta, interest expense, book value
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