WACC - Weighted Average Cost of Capital

WACC stands for Weighted Average Cost of Capital. This is also referred as MCC (Marginal Cost of Capital). In simple words, this is generally the rate of return which is being required by business to earn for paying off all the obligations such as Loans, Creditors, Preference Shareholders and Equity Shareholders. In other words, WACC is the required rate of return which the investors demand for above average risk investment of a company. 

Calculation

Generally, company raises capital from sources such as Debt, Equity and instruments which share the same characteristics of Debt and Equity. Most of the firms use more than one source of capital, so in order to get the overall cost of capital, we calculate WACC as follows:

1. Calculate the marginal cost for all sources of capital separately which has been used in the business i.e. Cost of equity, Cost of Debt & Cost of Preference Shares.

2. Then, find out the weights for every source of capital

3. Thereafter, multiply weights with cost of each source separately

4. Finally, Add all the figures to arrive at WACC

This formula can be written as:

WACC = Ke x We + Kd x Wd + Kp x Wp

Where,

Ke = Cost of Equity

We = Weight of equity capital in total capital structure

Kd = Cost of Debt

Wd = Weight of debt in total capital structure

Kp = Cost of Preference shares

Wp = Weight of Preference shares in total capital structure

Let’s understand the calculation with an example.

Company XYZ has 40 percent equity, 40 percent debt and 20 percent preferred stock. It’s before tax debt is 8 percent, its cost of preferred stock is 11 percent and its cost of equity is 14 percent. Tax rate is 35 percent. Find out the WACC (Weighted average cost of capital).

Solution:

WACC = Ke x We + Kd x Wd + Kp x Wp

= 0.14 x 0.40 + 0.08 x (1-tax rate) x 0.40 + 0.11 x 0.20

= 0.056 + 0.052 + 0.022

= 0.13 i.e. 13%

Note: Kd (Cost of debt) in this example is before tax debt so we multiplied this with {1-Tax rate} to arrive at after tax cost of debt. We always take after tax cost of debt for purpose of calculation because Interest expense acts as a tax shield and reduces the net taxable income which further reduces the tax amount.