For those of you that are unfamiliar with the various ratios used in the accounting world, they are used to gauge how successful a business is, telling not only the business’ management and owners, but also outside investors and creditors, how liquid, efficient, and profitable a company is. Our topic of discussion today is a little different. Unlike these other ratios, the weighted average cost of capital, or WACC for short, categorizes a company’s sources of capital, then finds out the costs of these capital sources, with each category being proportionately weighted. This may sound a little confusing, and we’ll try to explain WACC as clearly as possible, and if you’d like to learn more about the world of accounting, this article on accounting ratios, along with this course on basic accounting concepts should be good introductions.
WACC Formula Explained
WACC = [(E/V) x Re] + [((D/V) x Rd) x (1-Tc)]
- Re = Cost of equity
- Rd = Cost of debt
- E = Market value of equity
- D = Market value of debt
- V = E + D
- E/V = Percentage of financing that is equity
- D/V = Percentage of financing that is debt
- Tc = Corporate tax rate
That’s a lot to take it in, so let’s break down the components of this complex formula. The first part [(E/V) x Re] is how much the equity costs the company, and is found by multiplying its cost by what percentage of it is found in the company. The second part [(D/V) x Rd x (1-Tc)] deals with the debt portion. It finds its cost to the company like with the equity, by multiplying its cost times its percentage, then takes into account the tax rate (1-Tc).
Because the assets of a company are financed by either debt (bonds) or equity (stocks), it may be helpful to know what each of these sources cost to the company. What the WACC does is averages the costs of these two finance sources, after taxes, giving each an appropriate weighting, because more funding may come from one source compared to the other. By finding out this weighted average, a company is able to see how much interest must pay for every dollar it finances, or, in other words, it lets the company know how expensive it is for them to raise funds for buildings, equipment, and inventory. The lower a company’s WACC, the cheaper it is for them to fund new projects.
WACC is most often used internally by a company’s management and directors, and it helps to determine if any potential expansion or merger opportunities are economically feasible.
There are some important things to consider when calculating WACC:
- It must be computed after corporate taxes.
- It must consist of a weighted average of the marginal costs of all capital sources (debt, equity, etc.)
- Adjustments must be made for the inherent risk of each provider of capital.
- Long-term WACCs must must incorporate assumptions about long-term debt rates in addition to current rates.
Any more WACC considerations, and you’d need an accounting degree to fully understand them…or you can just check out our two in-depth accounting courses: this first accounting course on the basics, along with this second accounting course covering more advanced topics will prepare you for the WACC and any other accounting ratios thrown at you.
Example of WACC In Use
Jane’s Business Inc. (JBI) needs to expand and purchase some land and machinery that costs $1,000,000 all together. In order to raise this money, JBI decides to sell stocks and bonds. They issue 5,000 shares of stock at $80 each, and raise $400,000. The cost of this equity is 5%, because that’s the return on investment the shareholders expect.
Next, JBI sells 706 bonds for $850 each to raise the other $600,000 needed. These bonds cost the company 5%, because that’s the expected return. JBI’s new market value is $1,000,000 with a corporate tax rate of 32%. Let’s figure out JBI’s WACC using the formula we just learned.
WACC = [(400,000/1,000,000) x .05] + [((600,000/1,000,000) x .05) x (1-.32)] = .02 + (.03 x .68) = .040 (4.0%)
JBI’s WACC is 4.0%, meaning that for every dollar invested in the company, it must pay $.04 in return.
Hopefully you were able to understand the basics of the weighted average cost of capital. It’s a bit complex, so don’t get frustrated if it doesn’t quite make sense at first. It may help to have a little bit of a foundation in accounting, and if you’d like one, but don’t want to go overboard, bookkeeping might be the best avenue for you, and this course on the basics of bookkeeping might be just right.