Weighted average cost of capital (WACC) (ra) is a very simple concept. Weighted average cost of capital (WACC) refers to the weighted cost of both debt and equity financing, according to the firm’s specific optimal mix of financing (debt and equity). Knowing the weighted average cost of capital (WACC) enables better decision making about proposed projects.
The formula for weighted average cost of capital (WACC) (ra) is as follows:
WACC=(wd*rd)+(we*re)+(ws*rn or rr)
Where:
wd = a weight for the long-term debt
we = a weight for the preferred stock
we = a weight for the common stock
rd = the cost of long-term debt
re = the cost of preferred stock
rn = the cost of new common stock
rr = the cost of retained earnings
All sources of capital and their weights must be taken into account.
Example
Project Omega was proposed with an expected return of 9% and the firm’s cost of capital for debt financing is 7% and cost of capital for equity financing is 12%. Further, the optimal mix of debt and equity of the firm is 40 percent of debt and 60 percent of equity. Then, the weighted average cost of capital (WACC) is calculated as follows:
weighted average cost of capital (WACC) = 7% * 0.40 + 12% * 0.60
2.8 + 7.2 = 10%
The weighted average cost of capital (WACC) is 10%.
Given the information above, the proposed project with expected return of 9% should be rejected as it is below the firm’s 10% weighted average cost of capital (WACC).
When making investment decisions, business must only choose projects that bring returns higher than the weighted average cost of capital (WACC).
Test yourself
Company ABC has the following sources of capital:
Long-term debt at 7% after-tax cost with weight of 35% in the capital structure.
Preferred stock at 9% after-tax cost with weight of 10% in the capital structure.
Common stock at 14% after-tax cost with weight of 55% in the capital structure.
REQUIRED: Find the weighted average cost of capital (WACC).
SOLUTION:
weighted average cost of capital (WACC) =7%*.35+9%*.10+14%*.55
WACC=2.45+.9+7.7
WACC=11.05%
Calculating weights
As per above, to calculate the weighted average cost of capital (WACC) we need to know the weight of each source of financing. When calculating weights, market values or book values can be used. Market values evaluate the proportion of capital at the market value and book values evaluate the proportion of capital at the book (accounting) value. It is better to use market values, as it is a more realistic value.
Further, when calculating weights, we can use either target or historical proportions. Target proportions refer to the optimal capital mix that a business would like to achieve. Historical proportion refers to the proportion based on the past. The target proportion is preferred.
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Weighted average cost of capital (WACC) is a VERY important concept to understand. It is one of the central concepts in business and finance. The basic idea of weighted average cost of capital (WACC) concept is that it shows us the expected average cost of funds in the long-term. Make sure you are comfortable with explanations and calculations of the weighted average cost of capital (WACC) before progressing to the next section.
