WACC Formula (Table of Contents)
What is the WACC Formula?
The term “WACC” is the acronym for a weighted average cost of capital (WACC), which is a financial metric that helps in calculating a firm’s cost of financing by combining the cost of debt and cost of equity structure together. In other words, it indicates the minimum rate of return that a company needs to generate in order to compensate both shareholders and lenders. WACC is also known as the simple cost of capital.
Formula for WACC
The formula for WACC is expressed as the sum of the product of weightage of equity and cost of equity plus a product of weightage of debt, cost of debt and one minus the applicable tax rate. Mathematically, it is represented as,
Weightage of Equity = Total Equity / (Total Equity + Total Debt)
Weightage of Debt = Total Debt / (Total Equity + Total Debt)
Example of WACC Formula (With Excel Template)
Let’s take an example to understand the calculation of WACC in a better manner.
WACC Formula – Example #1
Let us take an example of a company DCF Inc. to illustrate the computation of WACC. During FY19, the company’s real estate investment generated a return of ~5.5%. As per the latest annual report, the company has an outstanding debt of $50.0 million and common equity valued at $70.0 million. During that period the company has incurred $2.0 million as interest expense on its debt. On the other hand, the risk-free rate of return is 1.5%, the market return is 4.0% and the company’s beta is 1.2x. Calculate WACC based on the given information and check whether the investment return of 5.5% exceeds its cost of capital if the tax rate is 32%.
Total Capital is calculated using the formula given below
Total Capital = Total Debt + Total Equity
- Total Capital = $50.0 million + $70.0 million
- Total Capital = $120.0 million
Weightage of Debt is calculated using the formula given below
Weightage of Debt = Total Debt / Total Capital
- Weightage of Debt = $50.0 million / $120.0 million
- Weightage of Debt = 0.417
Cost of Debt is calculated using the formula given below
Cost of Debt = Interest Expense / Total Debt
- Cost of Debt = $2.0 million / $50.0 million
- Cost of Debt = 4.0%
Weightage of Equity is calculated using the formula given below
Weightage of Equity = Total Equity / Total Capital
- Weightage of Equity = $70.0 million / $120.0 million
- Weightage of Equity = 0.583
Cost of Equity is calculated using the formula given below
Cost of Equity = Risk-Free return + Beta * (Market Return – Risk-free Return)
- Cost of Equity = 1.5% + 1.2 * (4.0% – 1.5%)
- Cost of Equity = 4.5%
WACC is calculated using the formula given below
WACC = Weightage of Equity * Cost of Equity + Weightage of Debt * Cost of Debt * (1 – Tax Rate)
- WACC = 0.583 * 4.5% + 0.417 * 4.0% * (1 -32%)
- WACC = 3.76%
Based on the given information, the WACC is 3.76%, which is comfortably lower than the investment return of 5.5%. Hence, it is a good idea to raise the money and invest.
The formula for WACC can be calculated by using the following points:
Typically, companies are financed by a mix of debt and equity. Further, the cost of debt is usually lower than that of the cost of equity and as such, it is important to capture the average cost of capital. However, it would be wrong if we take straight away the average of the cost of debt and cost of equity because in some cases companies might raise more funding from one source than another. As such, it is quintessential that we compute the weighted average of the cost of capital by taking into account the proportion of each category of funding (debt and equity) in the overall capital structure. Generally, companies intend to take more debt funding due to its lower cost of financing coupled with tax benefits for interest payment. The cost of two major sources of financing are as follows:
- Cost of Debt: The cost of debt of a company can be derived as interest expense for the year divided by the average outstanding debt. Mathematically, it is represented as,
Cost of Debt = Interest Expense / Amount of Outstanding Debt
- Cost of Equity: The cost of equity is expressed as the product of stock beta and difference of market return and risk-free return, which is then added to the risk-free return. In this case, equity is a generic name used for anything other than debt. Mathematically, it is represented as,
Cost of Equity = Risk-free return + Beta * (Market Return – Risk-Free Return)
Relevance and Use of WACC Formula
It is important that one understands the concept of WACC as it plays a vital role in making financial management decisions. The primary purpose of the formula for WACC is the assessment of the overall cost of funds based on the contribution of debt and equity in the company’s capital structure. Typically, the management of a company use WACC to evaluate whether it should finance the purchase of any new asset with equity or debt or a mix of both. Lower cost of financing is always desirable.
On the other hand, investors and creditors use WACC to evaluate whether it is worth investing or lending loan to an entity. As WACC increases, the investment will be less likely to create any value and as such investors might look for some other prospects.
So, it can be seen that WACC is a very useful metric in the financial domain for everyone. However, various everyone come up with a different WACC number for the same company due to a different set of assumptions.
WACC Formula Calculator
You can use the following WACC Formula Calculator
|WACC =||Weightage of Equity *Cost of Equity+Weightage of Debt*Cost of Debt* (1-Tax Rate)|
|=||0 *0+0*0*(1-0)= 0|
This is a guide to WACC Formula. Here we discuss how to calculate the WACC along with practical examples. We also provide a WACC Formula calculator with a downloadable excel template. You may also look at the following articles to learn more –