Calculate the Weighted Average Cost of Capital
When a business raises money by selling shares or receiving cash from investors, it is considered to be equity. Raising money by borrowing from a bank or issuing bonds qualifies as debt. Each of these methods has its own cost, which can be stated in terms of an interest rate.
A company's weighted average cost of capital (WACC) is the average interest rate it must pay to finance its assets, growth and working capital. The WACC is also the minimum average rate of return it must earn on its current assets to satisfy its shareholders, investors, or creditors.
The result of the WACC calculation is only an estimate. Multiple values in parts of the equation should be substituted to forecast investment possibilities.
The WACC is based on a company's capital structure (how it is financed) and is comprised of both debt financing and equity financing. Cost of capital is how much a firm pays to finance its operations (either debt or equity).
Included in the cost of capital are common stock, preferred stock, and debt. The cost of capital is how much interest a company pays on each form of financing.
Some small business firms only use debt financing for their operations. Other small startups only use equity financing, particularly if they are funded by equity investors such as venture capitalists. As these small firms grow, it is likely that they will use a combination of debt and equity financing.
Most of the time, WACC is used by investors as a measurement to indicate whether they should invest in a company.
The formula to calculate the WACC is:
WACC = ( ( E ÷ V ) x Re ) + ( ( ( D ÷ V ) x Rd ) x ( 1 - T ) )
Each of the values has either a formula or value you'll need to calculate or lookup. This information can be found on a company's balance sheet or financial information websites such as Yahoo Finance (find the ticker page for the company you are looking for). The values are defined as:
- Re=Cost of equity
- Rd=Cost of debt
- E=Market value of equity, or the market price of a stock (found on ticker page) multiplied by the total number of shares outstanding (found on balance sheet)
- D=Market value of debt, or the total debt of a company (found on balance sheet)
- T= Effective tax rate
- V=Total market value of combined equity and debt
Cost of Equity
The cost of equity can be a little more complex in its calculation than the cost of debt. It is possible that the firm could use both common stock and preferred stock to raise money for its operations. This illustration considers the cost of common stock only.
It is more difficult to estimate the cost of common stock than 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 retained earnings:
- The risk-free rate is usually estimated by using the rate of return on ten-year U.S. Treasury bills
- Estimate the expected return. You can use the historic rate of return from the company's ticker page. The ticker page lists a company's financial standing, and usually includes historical information
- Find the risk of the company's stock as compared to the market. Look for "Beta" on the company's stock summary page. If a company's risk is greater than the market, its beta is greater than 1.0, and less than 1.0 if the risk is lower.
- Use the CAPM formula to calculate the cost of equity
Risk Free Rate + [ Beta x ( Expected Market Return - Risk Free Rate ) ]
Cost of Debt
Small businesses may use short-term debt only to purchase their assets. For example, they may use supplier credit in the form of accounts payable. They could also just use short-term business loans, either from a bank or some alternative source of financing.
Larger businesses may use intermediate or long-term business loans or may even issue bonds to raise money for financing.
Use the following formula to calculate a company's effective interest:
Effective Interest rate = ( Annual Interest ÷ Total Debt ) x 100
Annual interest is the total amount of interest paid, and total debt is the total amount of debt a company has.
Then calculate the cost of debt:
Cost of Debt = Effective Interest x ( 1 - Marginal Tax Rate )
Market Value of Equity
The market value of equity refers to the value of the shares that are outstanding (all shares owned by shareholders or insiders). The formula is:
Market Value of Equity = Current Stock Price x Shares Outstanding
Market Value of Debt
The market value of debt is usually taken from the balance sheet (total debt) for this element of the WACC formula. You can also calculate the market value of debt if you have the information:
C [ ( 1 – ( 1 ÷ ( ( 1 + Kd ) t ) ) ) ÷ Kd ] + [ FV ÷ ( (1 + Kd ) t ) ]
- C= interest rate in dollars
- Kd=the current cost of debt (percentage, calculated previously)
- t=weighted average maturity (years average to maturity)
- FV=total debt
Effective Tax Rate
The effective tax rate is an average of the tax rate a company has paid. Generally, it is calculated by dividing total tax by their taxable income.
Effective Tax Rate = Income Tax Expense ÷ Earnings Before Taxes (EBT)
Total Market Value of Debt and Equity
Combine the market value of equity and market value of debt (calculated earlier) to arrive at the total market value of combined equity and debt.
Calculate the Weighted Average Cost of Capital
Once you have calculated the cost of capital for all the sources of debt and equity and gathered the other information needed, you can calculate the WACC.
WACC = ( ( E ÷ V ) x Re) + ( ( ( D ÷ V ) x Rd ) x ( 1 - T ) )
For example, if you were to find and calculate the following values from company financials:
The calculation would look like this:
( ( $5,600,000 ÷ $7,100,000 ) x .05 ) + ( ( ( $1,500,000 ÷ $7,100,000 ) x .04 ) x ( 1 - .21 ) ) =
.0394 + 0.0066 = .046 or 4.6%
The company you examined would have a WACC of 4.6%. This number represents the amount of money needed to pay investors per dollar of funding. In this example, it is $.046 per 1$ of funding. This is the average interest rate of payments to lenders and shareholders.
Taken by itself, the result only means what it says. It needs to be compared to other companies costs of capital to determine whether it is a worthwhile investment or not. Some investors may have personal guidelines about investing in a company with a WACC below a certain number, but in the end it is all up to personal preference and the amount of risk an investor is willing to take.