WACC
Properties
Weighted average cost of capital (WACC) is a company’s average after-tax cost of capital from all sources, including common stock, preferred stock, bonds, and other forms of debt. It represents the average rate that a company expects to pay to finance its business.
WACC is a common way to determine the required rate of return (RRR) because it expresses, in a single number, the return that bondholders and shareholders demand in return for providing the company with capital. A company’s WACC is likely to be higher if its stock is relatively volatile or if its debt is considered risky because investors will want greater returns to compensate them for the level of risk.
# Uses
- WACC is commonly used as a Hurdle Rate against which companies and investors can gauge the desirability of a given project or acquisition.
- WACC is also used as the discount rate for future cash flows in discounted cash flow analysis (DCF Discount Rate).
# Formula
\(WACC = \left( \frac{E}{V} \times R_e \right) + \left( \frac{D}{V} \times R_d \times (1 - T_c) \right)\)
Where:
- \(E = \text{Market value of the firm's equity}\)
- \(D = \text{Market value of the firm's debt}\)
- \(V = E + D\)
- \(R_e = \text{Cost of equity}\)
- \(R_d = \text{Cost of debt}\)
- \(T_c = \text{Corporate tax rate}\)
# Calculating Cost of Equity
Cost of equity (Re in the formula) can be a bit tricky to calculate because share capital does not technically have an explicit value. When companies reimburse bondholders, the amount they pay has a predetermined interest rate. On the other hand, equity has no concrete price that the company must pay. As a result, companies have to estimate the cost of equity (the rate of return that investors demand based on the expected volatility of the stock).
# Calculating Cost of Debt
Determining cost of debt (Rd in the formula), on the other hand, is a more straightforward process. This is often done by averaging the yield to maturity for a company’s outstanding debts. This method is easier if you’re looking at a publicly traded company that has to report its debt obligations.