what is weighted average cost of capital wacc 
weighted average cost of capital wacc represents a company s average after tax cost of capital from all sources including common stock preferred stock bonds and other forms of debt as such wacc is the average rate that a company expects to pay to finance its business wacc is a common way to determine required rate of return rrr because it expresses in a single number the return that bondholders and shareholders demand to provide the company with capital a company s wacc is likely to be higher if its stock is relatively volatile or if its debt is seen as risky because investors will want greater returns to compensate them jessica olah investopediaunderstanding wacccalculating a company s wacc is useful for investors and stock analysts as well company management although they may use it for different purposes in corporate finance determining a company s cost of capital can be important for a couple of reasons for instance wacc can be used as the discount rate for estimating the net present value of a project or acquisition if the company believes that a merger for example will generate a return higher than its cost of capital then it s likely a good choice for the company however if it anticipates a return lower than its investors are expecting then it might want to put its capital to better use 1to investors wacc is an important tool in assessing a company s potential for profitability in most cases a lower wacc indicates a healthy business that s able to attract money from investors at a lower cost by contrast a higher wacc usually coincides with businesses that are seen as riskier and need to compensate investors with higher returns if a company only obtains financing through one source say common stock then calculating its cost of capital would be relatively simple if investors expected a rate of return ror of 10 on their shares the company s cost of capital would be the same as its cost of equity 10 the same would be true if the company only used debt financing for example if the company paid an average yield of 5 on its bonds its cost of debt would be 5 this is also its cost of capital however many companies use both debt and equity financing in various proportions which is where wacc comes in wacc formula and calculationwacc e v r e d v r d 1 t c where e market value of the firm s equity d market value of the firm s debt v e d r e cost of equity r d cost of debt t c corporate tax rate begin aligned text wacc left frac e v times re right left frac d v times rd times 1 tc right textbf where e text market value of the firm s equity d text market value of the firm s debt v e d re text cost of equity rd text cost of debt tc text corporate tax rate end aligned wacc ve re vd rd 1 tc where e market value of the firm s equityd market value of the firm s debtv e dre cost of equityrd cost of debttc corporate tax rate wacc is calculated by multiplying the cost of each capital source debt and equity by its relevant weight and then adding those results together in the above formula e v represents the proportion of equity based financing while d v represents the proportion of debt based financing 1 the wacc formula thus involves the summation of two terms e v r e left frac e v times re right ve re d v r d 1 t c left frac d v times rd times 1 tc right vd rd 1 tc the former represents the weighted value of equity capital while the latter represents the weighted value of debt capital suppose that a company obtained 1 million in debt financing and 4 million in equity financing by selling common shares e v would equal 0 8 4 000 000 5 000 000 of total capital and d v would equal 0 2 1 000 000 5 000 000 of total capital wacc can be calculated using excel the biggest challenge is sourcing the correct data to plug into the model see investopedia s explanation of how to calculate wacc in excel explaining the formula elementscost of equity re in the formula can be a bit tricky to calculate because share capital does not technically have an explicit value when companies reimburse bondholders the amount they pay has a predetermined interest rate on the other hand equity has no concrete price that the company must pay as a result companies have to estimate the cost of equity in other words the rate of return that investors demand based on the expected volatility of the stock because shareholders will expect to receive a certain return on their investment in a company the equity holders required rate of return is a cost from the company s perspective if the company fails to deliver this expected return shareholders may simply sell their shares which can lead to a decrease in both share price and the company s value the cost of equity then is essentially the total return that a company must generate to maintain a share price that will satisfy its investors companies typically use the capital asset pricing model capm to arrive at the cost of equity in capm it s called the expected return of investment again this is not an exact calculation because companies have to lean on historical data which can never accurately predict future growth 2determining cost of debt rd in the formula on the other hand is a more straightforward process this is often done by averaging the yield to maturity for a company s outstanding debts this method is easier if you re looking at a publicly traded company that has to report its debt obligations for privately owned companies one can look at the company s credit rating from firms such as moody s and s p global and then add a relevant spread over risk free assets for example treasury bonds of the same maturity to approximate the return that investors would demand businesses are able to deduct interest expenses from their taxes 3 because of this the net cost of a company s debt is the amount of interest it is paying minus the amount it was able to deduct on its taxes this is why rd x 1 the corporate tax rate is used to calculate the after tax cost of debt wacc vs required rate of return rrr the required rate of return is the minimum rate that an investor will accept if they expect a smaller return than they require they ll put their money elsewhere one way to determine the rrr is by using the capm which looks at a stock s volatility relative to the broader market its beta to estimate the return that stockholders will require another method for identifying the rrr is by calculating wacc the advantage of using wacc is that it takes the company s capital structure into account that is how much it leans on debt financing vs equity 4limitations of waccthe wacc formula seems easier to calculate than it really is because certain elements of the formula such as the cost of equity are not consistent values various parties may report them differently for different reasons as such although wacc can often offer valuable insight into a company one should always use it along with other metrics in deciding whether to invest more complex balance sheets such as for companies using multiple types of debt with various interest rates make it more difficult to calculate wacc in addition there are many inputs to calculating wacc such as interest rates and tax rates all of which can be affected by market and economic conditions example of how to use waccconsider a hypothetical manufacturer called xyz brands suppose the market value of the company s debt is 1 million and its market capitalization or the market value of its equity is 4 million let s further assume that xyz s cost of equity the minimum return that shareholders demand is 10 here e v would equal 0 8 4 000 000 of equity value divided by 5 000 000 of total financing therefore the weighted cost of equity would be 0 08 0 8 0 10 this is the first half of the wacc equation now we have to figure out xyz s weighted cost of debt to do this we need to determine d v in this case that s 0 2 1 000 000 in debt divided by 5 000 000 in total capital next we would multiply that figure by the company s cost of debt which we ll say is 5 last we multiply the product of those two numbers by 1 minus the tax rate so if the tax rate is 0 25 then 1 minus tc is equal to 0 75 in the end we arrive at a weighted cost of debt of 0 0075 0 2 0 05 0 75 when that s added to the weighted cost of equity 0 08 we get a wacc of 0 0875 or 8 75 0 08 weighted cost of equity 0 0075 weighted cost of debt that represents xyz s average cost to attract investors and the return that they re going to expect given the company s financial strength and risk compared with other investment opportunities 