Business firms have to pay for their operations by either using 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 tax-adjusted interest you pay on the money you owe. The cost of equity financing is the market's risk-free rate plus a risk premium based on the inherent risk of the company. The flotation costs of new equity may also be significant.
If a business uses only one type of capital, the calculation of its cost of capital is easy.
If the business uses both debt and equity financing it gets more complicated. When more than one source of capital is used to finance a business firm's operations, then the calculation is an average of the costs of each and is called the weighted average cost of capital (WACC).
What Is the Weighted Average Cost of Capital?
A company's weighted average cost of capital is how much it pays for the money it uses to operate, stated as an average. It is also the minimum average rate of return it must earn on its assets to satisfy its investors. In other words, the amount the company pays to operate must approximately equal the rate of return it earns.
The WACC is based on a business firm's capital structure. The capital structure of a business firm is essentially the right-hand side of its balance sheet where its financing sources are listed. On the right-hand side of the balance sheet, there is a list of the debt and equity accounts of the firm.
The cost of capital is how much a firm pays to finance its operations through debt sources, equity sources, or some combination of the two.
Included in the cost of capital calculation is some combination of the liability, or debt accounts, except for current liabilities such as accounts payable. Also included are the shareholder's equity accounts including retained earnings and new common stock. When a business raises money by selling shares and receiving cash from investors, that is equity financing. Existing shareholder's equity may also be used for financing operations. Raising money by borrowing from a bank or issuing bonds qualifies as debt and the cost is interest charges to the business firm.
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 as follows:
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 on financial information websites. 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 multiplied by the total number of shares outstanding (found on the balance sheet)
- D = Market value of debt, or the total debt of a company (found on the balance sheet)
- T = Effective tax rate of the business firm
- V = Total market value of combined equity and debt
Components of Weighted Average Cost of Capital
Cost of Equity
The cost of equity can be a little more complex in its calculation than the cost of debt. 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 equity or common stock:
- The risk-free rate is usually estimated by using the rate of return on 10-year U.S. Treasury bills.
- Estimate the expected return. You can use the historic rate of return from the company's ticker page such as Yahoo! Finance or the company's annual report for this. 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 annual report or on a ticker page like Yahoo! Finance. 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 than the market as a whole.
- The expected market return at any given time is usually around 8%.
- Use the CAPM formula below to calculate the cost of the company's common stock.
Cost of Debt
Small businesses may use short-term debt only to purchase their assets. For example, they may use trade 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:
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:
The firm's marginal tax rate is the tax rate on the last $1 of income the firm makes.
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:
The shares outstanding for a business firm can be found on the firm's balance sheet.
Market Value of Debt
The market value of debt is usually taken from the balance sheet for this element of the WACC formula. You subtract accounts payable from total debt for this element of the equation.
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 taxable income.
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. It should equal 100%.
Calculating 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)
Let's look at an example. Your business has a capital structure of $7.1 million and it is made up 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 Stock (Re)
Re = Cost of Common Stock = Risk Free Rate + [Beta x (Expected Market Return - Risk Free Rate)]
The risk-free rate is around 3% and the expected market rate of return is around 8%. If your company is considered riskier than the market as a whole with a beta of 1.2, you can calculate the approximate return on your common stock as follows:
Re = 3% + [1.2(8% - 3%)] = 9%
Calculate the Cost of Debt
The cost of debt is the cost of the business firm's long-term debt. For the purpose of this example, let's say that the company has a mortgage on the building in which it is located in the amount of $150,000 at a 6% interest rate. The before-tax cost of debt is 6%.
Calculate the WACC
WACC = (($5,600,000/$7,100,000) X .09 + (($1,500,000/$7,100,000) X .06 X (1-0.21)
= 0.79 X .09 + 0.21 X .06 X .79
= 7 + 0.99
Taken by itself, the result means that this business firm has a WACC of 7.99%. On average, it pays 7.99% to obtain financing for its operations. That means that the firm's goal for return on its assets should be at least 7.99%. The WACC is used as the discount rate used in the Net Present Value calculation that we use in evaluating capital budgeting projects.