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.
|= 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
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?
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).
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.