Contents

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

Weighted Average Cost of Capital, as the name suggests, is a weighted average of the various costs of capital and weighted by their respective proportion in the capital structure. Let me explain.

## Formula

= rE*[E/(E+D+P)] | Cost of common equity, weighted by proportion of common equity |

+ rP*[P/(E+D+P)] | Cost of preferred, weighted by proportion of preferred |

+ rD*(1-T)*[E/(E+D+P)] | After-tax Cost of debt, weighted by proportion of equity |

= Weighted Average Cost of Capital (WACC) |

- rE is cost of common equity, E is $ value of common equity in capital structure
- rP is cost of preferred equity, P is $ value of preferred equity in capital structure
- rD is cost of debt, D is $ value of debt in capital structure
- T is tax rate

### Example

If a firm’s capital structure is comprised of 70% equity and 30% debt, with a cost of equity of 10% and a cost of debt of 5%, what is the Weighted Average Cost of Capital?

## Components

## Cost of Equity

The cost of equity is typically obtained (at least in interview questions) using the Capital Asset Pricing Model.

## Cost of Debt

The cost of debt is adjusted for taxes. Interest payments made to service debt reduces taxable income which represents a savings to the firm and lowers the effective cost of the debt. The pre-tax cost of debt can be obtained using debt comps (looking at similar companies and debt levels to estimate the cost of debt) or a debt schedule (what debt the firm has and how much it’s paying for it).

### Example

If you manufacture widgets and want to take on $100 of debt, a good way to find that cost would be to look at a similar manufacturer of widgets of the same size, profitability, growth potential, etc. and see how much it’s paying for $100 of debt.