What is WACC (Weighted Average Cost of Capital)?
Weighted average cost of capital is the rate at which a company is expected to pay on average to all its stake holders including creditors and share holders.
In weighted average cost of capital, all types of capital are proportionately weighted.
Our WACC calculator accounts for cost of equity and cost of debt after tax, following the WACC formula mentioned below:
WACC is the weighted average cost of capital,
Re is the cost of equity,
Rd is the cost of debt,
E is the market value of the company’s equity,
D is the market value of the company’s debt,
t is the corporate tax rate.
Cost of Equity:
Cost of equity represents the rate of return a company is expected to its equity investors.
A company uses cost of equity to evaluate the required rate of return on both internal and external projects.
Cost of equity is usually higher than cost of debt, since interest payments on debt are tax deductible and debt needs to be repaid at the end of term. While equity does not need to be repaid (represents higher risk involved) and dividend payments are not tax deductible.
How to calculate cost of equity?
There are two common methods of calculating cost of equity. CAPM (Capital Asset Pricing Model) and Dividend Capitalization Model.
Capital Asset Pricing Model (CAPM)
E(Ri) = Rf + βi * [E(Rm) – Rf]
E(Ri) = Expected return on asset i
Rf = Risk-free rate of return
βi = Beta of asset i
E(Rm) = Expected market return
Dividend Capitalization Model
Dividend Capitalization Model accounts for company’s dividend payout history and expected growth rate.
Dividend Capitalization Model Formula:
Re = (D1 / P0) + g
Re = Cost of Equity
D1 = Dividends/share next year
P0 = Current share price
g = Dividend growth rate
How to calculate weighted average cost of capital?
Example: Suppose we have following data of a company:
Equity (E) = $22,500
Debt (D) = $7,500
Rd = 7%
Re = 14%
Corporate Tax Rate (t) = 25%
The WACC can be calculated as follows:
WACC Formula = (E / V) × Re + (D / V) × Rd × (1 − t)
WACC = [(22500 / 22500 + 7500) × 0.14] + [(7500 / 22500 + 7500) × 0.07 × (1 − 0.25)]
WACC = 0.1050 + 0.01312
WACC = 0.1181 or 11.81%, the WACC of the company is 11.81%.
It is important to mention that the lower the WACC, the market value of the company will be higher. To determine if the WACC is lower, the WACC of the similar companies should be compared to the WACC of company in the question.
Higher WACC represents the associated risk of operations.
Check out this Google sheet – WACC Calculator