Weighted Average Cost of Capital
Here is the basic formula to calculate for weighted average cost of capital (WACC):
WACC = (( E / V ) * Re) + [( ( D / V ) * Rd) * (1-T)]
E = Market value of the business entity’s equity
D = Market value of the business entity’s debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity | based on risk-free interest plus risk elements (see link)
Rd = Cost of Debt | based on the current market rate of debt for this specific business entity
T= Tax Rate | effective tax rate for the business entity
A company is typically financed using a combination of debt (bonds) and equity (stocks). Because a company may receive more funding from one source than another, we calculate a weighted average to find out how expensive it is for a company to raise the funds needed to buy buildings, equipment, and inventory.
Let’s look at an example:
Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000 shares of stock at $100 each to raise the first $600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.
Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital. The people who bought those bonds expect a 5% return, so ABC’s cost of debt is 5%.
Corporation ABC’s total market value is now ($600,000 equity + $400,000 debt) = $1 million and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation ABC’s weighted average cost of capital (WACC).
WACC = (($600,000/$1,000,000) x .06) + [(($400,000/$1,000,000) x .05) * (1-0.35))] = 0.049 = 4.9%
Corporation ABC’s weighted average cost of capital is 4.9%.
This means for every $1 Corporation ABC raises from investors, it must pay its investors (shareholders and debt-holders) almost $0.05 in return.
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