A guide to weighted average cost of capital (WACC)
A guide to WACC: all you need to know
As far as abbreviations go, WACC can be a bit of an eyebrow-raiser at first. The good news is, once you understand the value of your equity and debt, it becomes relatively easy. No one expects you to do this by hand, of course (unless you’re a maths wiz!). We’d recommend using Microsoft Excel or Google Sheets to make your calculations.
WACC refers to the “weighted average cost of capital” and calculates a company’s cost if each category is proportionality weighted. This may include stock, bonds, and any long-term debt.
Essentially, it indicates the minimum rate of return that a company needs to generate to compensate both shareholders and lenders. WACC is also known as the simple cost of capital.
Read on to find out why WACC is important for your business, and how to calculate it.
Why is WACC used?
WACC is used by businesses to make internal decisions. By taking a weighted average, it shows how much interest a company would owe for every pound it finances. So, it can be really valuable to businesses that are considering expansion or merger opportunities.It is also used by lenders. WACC shows lenders the opportunity cost of investing in a company and how much of a return they can expect from their investment.
What is the WACC formula?
WACC is calculated by multiplying the cost of each capital source, such as equity (stocks and bonds) and debt, by its relevant weight. You then add the products together to determine the value.
The formula for WACC is: multiply the cost of capital source by relevant weight by the market value, then add these together to determine the total.
So, to calculate WACC, we first need to know what our cost of equity and cost of debt is. The cost of equity is the amount that a company must spend to maintain a share price that will satisfy its investors.
In comparison, to calculate the cost of debt, you use the market rate that a company is currently paying on its debt. Because companies get a tax deduction on interest paid on debt, you must calculate the amount saved in taxes due to its tax-deductible interest payment. This is the corporate tax rate part of the equation above.
How to calculate cost of equity?
The cost of equity is the amount that a company must spend to maintain a share price that will satisfy its investors. In comparison, to calculate the cost of debt, you use the market rate that a company is currently paying on its debt. Because companies get a tax deduction on interest paid on debt, you must calculate the amount saved in taxes due to its tax-deductible interest payment. This is the corporate tax rate part of the equation above.
The cost of equity is difficult to measure precisely. This is because a company does not pay interest on outstanding shares of stock, and each share does not have a specific value or price. A company simply issues stock to investors for whatever they are willing to pay and at any given time. This means that if the stock is in high demand, the price will be high; however, if the market is low, the prices will be low. Since there is very little stability in the stock market, it’s very difficult to measure the cost of equity.
Investors buy stock with the expectation that they will get a return on their investment. This expectation establishes the required rate of return that a company must pay its investors to prevent them from selling their shares. Therefore, the cost of equity is the amount of money that a company must spend to satisfy its shareholders and to keep its stock at a relatively stable price.
How to calculate cost of debt?
The cost of debt is much easier to work out: you simply calculate what your company owes in debt and subtract its interest rate. You should use the market interest rate or the rate that the company is currently paying. Since interest expenses are usually deductible, the WACC formula also considers tax savings made through interest payments.
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