What is the weighted average cost of capital?

Introduction

Commercial companies need to pay for their operations either through debt financing or equity financing or some combination of both. These sources of money or capital have a cost. The cost of debt financing is the after-tax interest you pay on the money you owe. The cost of equity financing is the risk-free rate of return in the market plus a risk premium based on the inherent risks of the company. The costs of a public offering of new equity can also be significant.

What is the Weighted Average Cost of Capital?

The weighted average cost of capital (WACC) for a company is the amount it pays to use the money it uses in operations, expressed as an average. It is also the minimum average rate that it needs to earn on its assets to satisfy investors. In other words, the amount the company pays to operate should roughly equal the rate of return it achieves.

The WACC is based on the company’s capital structure. The capital structure of a business is the right side of its balance sheet where its sources of financing are listed. On the right side of the balance sheet, there are listings of the company’s debt and equity accounts.

Components of the Weighted Average Cost of Capital

Cost of Equity: The cost of equity can be more complicated to calculate than the cost of debt. It is harder to estimate the cost of common stock than to estimate the cost of debt. Most businesses use the Capital Asset Pricing Model (CAPM) to estimate the cost of equity. Here are the steps to estimate the cost of equity or common stock:

Cost of Debt: Small businesses may use short-term debt only to purchase their assets. For example, they might use trade credit in the form of accounts payable. They can also use short-term business loans, either from a bank or an alternative financing source.

Market Value of Equity: The market value of equity refers to the value of the stocks owned (all stocks owned by shareholders or insiders). The number of outstanding shares of a business can be found on the company’s balance sheet.

Market Value of Debt: The market value of debt is usually taken from the balance sheet for that item in the WACC formula. Accounts payable are subtracted from the total debt for that item in the equation.

Effective Tax Rate: The effective tax rate is the average tax rate that the company has paid. It is generally calculated by dividing total taxes by taxable income.

Total Value of Debt and Equity: Add the market value of equity and the market value of debt (calculated earlier) to arrive at the total combined value of debt and equity. Together, they should equal 100%.

Calculating the Weighted Average Cost of Capital

Once the capital costs for all sources of debt and equity have been calculated and other necessary information has been gathered, you can calculate the WACC: WACC = [(E ÷ V) x Re] + [(D ÷ V) x Rd] x (1 – T)

Let’s look at an example. You have a business with a capital structure worth $7.1 million consisting of $5.6 million in equity and $1.5 million in debt. E = $5,600,000 D = $1,500,000 Tax rate (T) = 21%

Calculate the cost of common equity (Re): Re = cost of common equity = risk-free rate + [beta x (expected market return – risk-free rate)]

Calculate the cost of debt: The cost of debt is the long-term cost of the company’s debt. For the purpose of this example, let’s assume the company has a mortgage on the building it occupies worth $150,000 at an interest rate of 6%. The pre-tax cost of debt is 6%.

Calculate

Weighted Average Cost of Capital: WACC = (($5,600,000 / $7,100,000) × 0.09) + (($1,500,000 / $7,100,000) × 0.06 × (1-0.21) = 0.79 × 0.09 + 0.21 × 0.06 × 0.79 = 7 + 0.99 = 7.99%

By itself, the result means that this company has a weighted average cost of capital of 7.99%. On average, it pays 7.99% to obtain financing for its operations. This means that the company’s target return on assets should be at least 7.99%. The weighted average cost of capital is used as the discount rate in calculating the net present value that we use in evaluating capital budgeting projects.

Source: https://www.thebalancemoney.com/calculate-weighted-average-cost-of-capital-393130