What is WACC Formula?
WACC Formula is a calculation of a firm’s cost of capital in which each category is proportionally weighted. It is the average rate that a company is expected to pay to its stakeholders to finance its assets. In simple terms the minimum return that the firm should earn on the existing asset base so that the investors and lenders are interested, or they will invest elsewhere.
Basic terminology of the WACC Formula is as follows –
Mathematically, Weighted Average Cost of Capital Formula can be expressed as –
- E = Market cap i.e. Market value of the firm’s equity
- D = Market value of the firm’s debt
- V = total value of the capital or total value of firm’s financing = D + E
- E/V = percentage of capital that is equity
- D/V = percentage of capital that is debt
- Re = cost of equity (required rate of return)
- Rd = cost of debt
- Tc = Corporate tax rate
Explanation of Weighted Average Cost of Capital Formula
Part 1 – Cost of Equity:
The cost of equity is difficult to measure because a company doesn’t pay any interest on this amount. Issuing stocks is free for a firm as it raises equity capital and pays a cost in the form of dilution of ownership. Also, each share doesn’t have any specified value. At any point in time, the price of a share is determined by the amount the investors are willing to pay to participate in the growth story of the firm. Hence it is only an anticipated value and not a fixed number.
The best way to measure the cost of equity is to quantify this expected value. It is an implied cost or an opportunity cost of capital. It is the return that shareholders expect in order to compensate for the risk they undergo when they invest their capital in the equity (stock). We can use the CAPM Model in such a scenario.
Re = Rf + B X (Rm-Rf)
- Rf = Risk-free rate. It is the return that can be earned by investing in riskless security, for example, US treasury bonds, hence the name risk-free. For all financial models 10-year US Treasury is used as the risk-free rate.
- Rm = Annual return of the market
- B = Equity Beta. It is the measure of the stock’s volatility of returns compared to a benchmark index like S&P 500 or NIFTY 50. It is calculated using the historical returns of the stock relative to the benchmark returns. It provides a view to investors to –
- Understand the direction of the stock movement compared to the market/benchmark
- The volatility of the stock compared to the volatility of the market.
Part 2 – Cost of Debt:
Compared to the cost of equity, cost of debt is relatively easy to calculate as it is not an expected value in the future but a predetermined rate that has been agreed on by the firm before issuing any bonds to the investors. We can use the market interest rate or the actual interest rate that the firm has promised to the debt holders. An example can be corporate issuing corporate bonds for an interest rate of 8%. Here irrespective of the prevailing market deposit rates, the firm has promised a coupon rate of 8% per annum and the principal amount at maturity to the investors.
You might notice we have an additional factor (1 – Tc) multiplied by the cost of debt in the WACC Formula. This is because there are additional tax implications with these interest expenses.
An extended version of the WACC Formula for the companies that have preferred stock is as follows –
WACC Formula = Cost of equity * % Equity + Cost of Debt * % Debt * (1 – tax rate) + Cost of preferred stock * % preferred stock
Example of WACC Formula (with Excel Template)
Let’s take a practical example to understand the Weighted Average Cost of Capital Formula (WACC)-
Assume a firm Photon limited that needs to raise capital to buy machinery, land for office space and recruit more staff to conduct day to day business activities. Let’s say that the firm decided that it needs an amount of $ 1 million for the same. The firm can raise capital through 2 sources – Equity and Debt.
- It issues 50,000 shares at $ 10 each and raises $ 500,000 through equity. As investors expect a return of 7 %, the cost of equity is 7 %.
- For the remaining $ 500,000, firm issues 5000 bonds at $ 100 each. The bondholders expect a return of 6%, hence Photon’s cost of debt will be 6 %.
- Additionally, let’s assume the effective tax rate is 35%.
Substituting these values in the WACC
So now we can calculate the Weighted Average Cost of Capital.
WACC Formula = E/ V * Re + D/V *Rd *(1-Tc)
i.e WACC formula = (500,000/1,000,000 * 0.07) + (500,000/1,000,000 * 0.06) * (1 – 0.35)
So the result will be:
You can use the following WACC Calculator.
|WACC Formula =||[Cost of Equity x % of Equity] + [Cost of Debt x % of Debt x (1 − Tax Rate)]|
|[0 * 0] + [0 * 0 * (1 − 0)] =||0|
Relevance and Uses
- Weighted Average Cost of Capital Formula provides a weighted average of financing which helps in determining how much interest a company owes for each dollar it finances.
- WACC formula as a metric is helpful for the Board of directors and business heads to gauge the economic feasibility of mergers and acquisitions and other inorganic growth opportunities. The lower the firm’s WACC, the lower it is for the business to fund new ventures.
- Securities analysts, rating agencies and other research analysts evaluate the value of investments and firm using WACC. WACC formula can be used in discounted cash flow analysis to derive the net business value of the firm. Similarly, it can be used in calculating the hurdle rate to derive ROI and economic value calculations.
- Last but not least, investors can use WACC to determine if an investment is worth pursuing. For example, if the firm generates a return of 12% but a WACC of 14%, then the firm is losing 2% on every dollar spent. In that case, investors can drop this investment from their portfolio.
This has been a guide to WACC Formula. Here we discuss its uses along with practical examples to understand WACC. Here we also provide you with WACC Calculator with downloadable excel template. You can learn more about Excel Modeling from the following articles –