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What is the Weighted Average Cost of Capital (WACC)?

by Jason Varner Financial Projections Template
Businesses often use capital from different sources, which categorized into debt and equity. Liability (debt) can include bank loans and issued bonds, while ownership (equity) includes stocks and investment from investors. All these capitals come with a cost, and the fees vary as to the sources of funds. The cost of debt is the bank's interest rate for issuing a loan to the company less than the tax benefit. You need to give back more what you owe as the compensation for borrowing the capital. On the other hand, the cost of equity is the expected rate of return of the investors who put in money to your business. The cost of equity is equal to the opportunity cost if the money would be invested elsewhere in a company with a similar risk profile.

It is a misunderstanding that there is no concrete cost of equity. We all know that an investor is expecting a rate of return upon investing in the company. If that doesn't meet, the investor will pull out his/her investment, leaving you in smaller capital to use for your business. The Capital Asset Pricing Model (CAPM) can be used to compute for the cost of equity. CAPM is a model utilized to establish the risk and expected return on assets to evaluate the required returns for stocks. The determining parameters include the risk-free interest rate from Government bonds, market-risk premium, company's beta, and, eventually, other risk adjustment factors.

WACC is the average after-cost of a company's various capital sources, which means that it is the weighted rate the company expects to pay its assets. It is the average cost in raising the money, calculated in proportion to each of the sources. WACC is computed by multiplying the source of capital by its relative weight, then add these together to come up with the Weighted Average Cost of Capital for the company.

WACC Calculator

So how do we compute for WACC? Weighted Average Cost of Capital derived using the formula below:

WACC = (E/V x Re) + (D/V * Rd * (100% - Tc)

Whereas:

E = Market Value of the Firm's Equity

D = Market Value of the Firm's Debt

V = E + D

Re = Cost of Equity = risk-free interest rate + market risk premium * beta + additional risk adjustment factor

Rd = Cost of Debt

Tc = Corporate Tax Rate

To better understand the concept of WACC Calculator, let's take the following example. Let's say that your capital coming from equity is $200,000, with an estimated cost of equity of 12%. The borrowed capital is $150,000, with an interest rate of 8%. Let's assume a corporate tax rate of 20%. We will substitute the figures in the formula.

WACC = (E/V x Re) + (D/V * Rd * (1 - Tc)

WACC = (200,000/350,000 x 12%) + (150,000/350,000 x 8% x (1-20%)

WACC = 6.86% + 2.74%

WACC = 9.60%

If the rate of return of your business is more than 9.60%, then it is a profitable venture since your cost of capital is already recovered and the excess serves as the business profit.

WACC is an essential concept in computing for the cost of capital since it considered different factors in deriving the weighted average. These theoretical models allow a quite precise estimation of the WACC. To understand the factors which are affecting the WACC, download a WACC Calculator from efinancialmodels.com.

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About Jason Varner Innovator   Financial Projections Template

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Joined APSense since, February 16th, 2018, From Zurich, Switzerland.

Created on Apr 10th 2020 03:51. Viewed 358 times.

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