11/2/2019 Weighted Average Cost of Capital – WACC Definition
CORPORATE FINANCE & ACCOUNTING FINANCIAL RATIOS
Weighted Average Cost of Capital – WACC
REVIEWED BY MARSHALL HARGRAVE | Updated Jun 30, 2019
TABLE OF CONTENTS
What Is WACC?
WACC Formula and Calculation
Calculating WACC in Excel
Explaining the Formula Elements
EXPAND +
Learning From WACC
What Is Weighted Average Cost of Capital – WACC?
The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in
which each category of capital is proportionately weighted. All sources of capital, including
common stock, preferred stock, bonds, and any other long-term debt, are included in a
WACC calculation.
A firm’s WACC increases as the beta and rate of return on equity increase because an increase
in WACC denotes a decrease in valuation and an increase in risk. (For related insight, read
What Does a High Weighted Average Cost of Capital (WACC) Signify?)
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11/2/2019 Weighted Average Cost of Capital – WACC Definition
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Weighted Average Cost Of Capital (WACC)
WACC Formula and Calculation
E D
WACC = ∗ Re + ∗ Rd ∗ (1 − T c)
V V
where:
Re = Cost of equity
Rd = Cost of debt
E = Market value of the firm’s equity
D = Market value of the firm’s debt
V = E + D = Total market value of the firm’s financing
E/V = Percentage of financing that is equity
D/V = Percentage of financing that is debt
Tc = Corporate tax rate
To calculate WACC the analyst will multiply the cost of each capital component by its
proportional weight. The sum of these results is, in turn, multiplied by the corporate tax rate,
or 1. Apply the following values to the formula listed above:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Calculating WACC in Excel
The weighted average cost of capital (WACC) can be calculated in Excel. The biggest part is
sourcing the correct data to plug into the model. See Investopedia’s notes on how to
calculate WACC in Excel.
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11/2/2019 Weighted Average Cost of Capital – WACC Definition
KEY TAKEAWAYS
Calculation of a firm's cost of capital in which each category of capital is
proportionately weighted.
Incorporates all sources of a company’s capital—including common stock, preferred
stock, bonds, and any other long-term debt.
Can be used as a hurdle rate against which companies and investors can gauge ROIC
performance.
WACC is commonly used as the discount rate for future cash flows in DCF analyses.
Explaining the Formula Elements
Cost of equity (Re) can be a bit tricky to calculate since share capital does not technically
have an explicit value. When companies pay a debt, the amount they pay has a
predetermined associated interest rate that debt depends on the size and duration of the
debt, though the value is relatively fixed. On the other hand, unlike debt, equity has no
concrete price that the company must pay. Yet that doesn't mean there is no cost of equity.
Since shareholders will expect to receive a certain return on their investments in a company,
the equity holders' required rate of return is a cost from the company's perspective, because
if the company fails to deliver this expected return, shareholders will simply sell off their
shares, which leads to a decrease in share price and in the company’s value. The cost of
equity, then, is essentially the amount that a company must spend in order to maintain a
share price that will satisfy its investors.
Calculating the cost of debt (Rd), on the other hand, is a relatively straightforward process.
To determine the cost of debt, you use the market rate that a company is currently paying on
its debt. If the company is paying a rate other than the market rate, you can estimate an
appropriate market rate and substitute it in your calculations instead.
There are tax deductions available on interest paid, which are often to companies’ benefit.
Because of this, the net cost of a company's debt is the amount of interest it is paying, minus
the amount it has saved in taxes as a result of its tax-deductible interest payments. This is
why the after-tax cost of debt is Rd (1 - corporate tax rate).
Learning From WACC
WACC is the average of the costs of these types of financing, each of which is weighted by its
proportionate use in a given situation. By taking a weighted average in this way, we can
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11/2/2019 Weighted Average Cost of Capital – WACC Definition
determine how much interest a company owes for each dollar it finances.
Debt and equity are the two components that constitute a company’s capital funding.
Lenders and equity holders will expect to receive certain returns on the funds or capital they
have provided. Since the cost of capital is the return that equity owners (or shareholders)
and debt holders will expect, WACC indicates the return that both kinds of stakeholders
(equity owners and lenders) can expect to receive. Put another way, WACC is an investor’s
opportunity cost of taking on the risk of investing money in a company.
A firm's WACC is the overall required return for a firm. Because of this, company directors will
often use WACC internally in order to make decisions, like determining the economic
feasibility of mergers and other expansionary opportunities. WACC is the discount rate that
should be used for cash flows with the risk that is similar to that of the overall firm.
To help understand WACC, try to think of a company as a pool of money. Money enters the
pool from two separate sources: debt and equity. Proceeds earned through business
operations are not considered a third source because, after a company pays off debt, the
company retains any leftover money that is not returned to shareholders (in the form of
dividends) on behalf of those shareholders.
Who Uses WACC
Securities analysts frequently use WACC when assessing the value of investments and when
determining which ones to pursue. For example, in discounted cash flow analysis, one may
apply WACC as the discount rate for future cash flows in order to derive a business's net
present value. WACC may also be used as a hurdle rate against which companies and
investors can gauge return on invested capital (ROIC) performance. WACC is also essential in
order to perform economic value-added (EVA) calculations.
Investors may often use WACC as an indicator of whether or not an investment is worth
pursuing. Put simply, WACC is the minimum acceptable rate of return at which a company
yields returns for its investors. To determine an investor’s personal returns on an investment
in a company, simply subtract the WACC from the company’s returns percentage.
WACC vs. Required Rate of Return – RRR
The required rate of return (RRR) is from the investor’s perspective, being the minimum rate
an investor will accept for a project or investment. Meanwhile, the cost of capital is what the
company expects to return on its securities. Learn more about WACC versus the required rate
of return.
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11/2/2019 Weighted Average Cost of Capital – WACC Definition
Limitations of WACC
The WACC formula seems easier to calculate than it really is. Because certain elements of the
formula, like the cost of equity, are not consistent values, various parties may report them
differently for different reasons. As such, while WACC can often help lend valuable insight
into a company, one should always use it along with other metrics when determining
whether or not to invest in a company.
Example of How to Use WACC
Suppose that a company yields returns of 20% and has a WACC of 11%. This means the
company is yielding 9% returns on every dollar the company invests. In other words, for each
dollar spent, the company is creating nine cents of value. On the other hand, if the
company's return is less than WACC, the company is losing value. If a company has returns of
11% and a WACC of 17%, the company is losing six cents for every dollar spent, indicating
that potential investors would be best off putting their money elsewhere.
As a real-life example, consider Walmart (NYSE: WMT). The WACC of Walmart is 4.2%. That
number is found by doing a number of calculations. First, we must find the financing
structure of Walmart to calculate V, which is the total market value of the company’s
financing. For Walmart, to find the market value of its debt we use the book value, which
includes the long-term debt and long-term lease and financial obligations.
As of the end of its most recent quarter (Oct. 31, 2018), its book value of debt was $50 billion.
As of Feb. 5, 2019, its market cap (or equity value) is $276.7 billion. Thus, V is $326.7 billion,
or $50 billion + $276.7 billion. Walmart finances operations with 85% equity (E / V, or $276.7
billion / $326.7 billion) and 15% debt (D / V, or $50 billion / $326.7 billion).
To find the cost of equity (Re) one can use the capital asset pricing model (CAPM). This model
uses a company’s beta, the risk-free rate and expected return of the market to determine the
cost of equity. The formula is risk-free rate + beta * (market return - risk-free rate). The 10-
year Treasury rate can be used as the risk-free rate and the expected market return is
generally estimated to be 7%. Thus, Walmart’s cost of equity is 2.7% + 0.37 * (7% - 2.7%), or
4.3%.
The cost of debt is calculated by dividing the company’s interest expense by its debt load. In
Walmart’s case, its recent fiscal year interest expense is $2.33 billion. Thus, its cost of debt is
4.7%, or $2.33 billion / $50 billion. The tax rate can be calculated by dividing the income tax
expense by income before taxes. In Walmart’s case, it lays out the company’s tax rate in the
annual report, said to be 30% for the last fiscal year.
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11/2/2019 Weighted Average Cost of Capital – WACC Definition
Finally, we’re ready to calculate Walmart’s weighted average cost of capital (WACC). The
WACC is 4.2%, with the calculation being 85% * 4.3% + 15% * 4.7% * (1 - 30%).
Related Terms
Financing: What It Means and Why It Matters
Financing is the process of providing funds for business activities, making purchases, or investing.
Financial institutions such as banks are in the business of providing capital to businesses, consumers,
and investors to help them achieve their goals. more
Composite Cost Of Capital
Composite cost of capital is a company's cost to finance its business, determined by and commonly
referred to as "weighted average cost of capital" (WACC). more
Traditional Theory of Capital Structure Definition
The Traditional Theory of Capital Structure states that a firm's value is maximized when the cost of
capital is minimized, and the value of assets is highest. more
Cost of Capital: What You Need to Know
Cost of capital is the required return a company needs in order to make a capital budgeting project,
such as building a new factory, worthwhile. more
Understanding Optimal Capital Structure
An optimal capital structure is the mix of debt, preferred stock, and common stock that maximizes a
company’s stock price by minimizing its cost of capital. more
How to Use the Hamada Equation to Find the Ideal Capital
Structure
The Hamada equation is a fundamental analysis method of analyzing a firm's cost of capital as it uses
additional financial leverage and how that relates to the overall riskiness of the firm. more
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11/2/2019 Weighted Average Cost of Capital – WACC Definition
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