# Weighted Average Cost of Capital (WACC)

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?

## 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.