The WACC equation is:
which can be written as:
which can be written as:
is the cost of equity
is the cost of debt
The cost of equity and the cost of debt are percentages that are weighted by how much debt and equity a company is using to finance itself.
The total financing for a company is its Debt + Equity.
Equity / Debt + Equity is the proportion of equity financing and Debt / Debt + Equity is the proportion of debt financing.
The weighted average cost of capital (WACC) is the rate companies pay lenders and shareholders for the use of their funds. It is a weighted average of the cost of debt (paid to lenders) and the cost of equity (paid to shareholders).
Use the WACC to determine what discount rate to use in capital budgeting decisions (e.g. in an NPV calculation). Use the WACC to evaluate potential investments.
Companies are financed through two ways:
Examples include IPOs and selling shares in a start-up to venture capitalists (VCs).
Both ways have a cost associated with them. Lenders expect to be paid an interest on their loan. Shareholders expect their shares in the company to increase in value and may receive dividend payments.
The WACC is weighted by the proportion of debt and equity in the capital structure. If more debt is used, then the WACC is closer to the cost of debt. Similarly if more equity is used, the WACC will be more similar to the cost of equity.
The WACC is often used as the discount rate in a Net Present Value (NPV) calculation or a discounted cash flow (DCF) model.
Because the WACC is a weighted average of the cost of equity and the cost of debt, we need to first calculate the cost of equity and then the cost of debt separately.
The cost of debt is relatively easier to measure. There are a few methods you can use to find company’s cost of debt.
Interest payments: If a company already has outstanding loans, you can use the current interest rates on those loans.
Bonds: Companies can issue bonds to raise money. Bonds are a form of debt. The cost of debt for these bonds is the yield to maturity. If the company’s corporate bonds are publicly traded, you can observe their market prices and calculate their yield to maturity.
Credit worthiness: The yield of maturity of corporate bonds cannot be calculated if the bonds are not traded in the public market. In this case, you can consider what kinds corporate bond yields a company could get based on its credit worthiness. Credit worthiness for companies is measured by three primary credit rating agencies:
Companies with better credit — a lower probability of default — tend to have the lowest yield to maturities, and a lower cost of debt. Those with higher probability of default will have higher yield of maturities, and a higher cost of debt.
Because interest expenses on debt is often tax-deductible, we use the after tax cost of debt.
The cost of equity is the rate of return investors expect to get from investing in a company’s stock. This return comes in the form of cash distributions, which are cash proceeds from sale of the stock and any dividend payouts.
The cost of equity is more difficult to calculate.
There are two common methods of calculating the cost of equity:
The dividend growth model estimates the future dividends a shareholder expects to receive. Using (1) the current stock price and (2) the future stream of dividends, we can calculate the internal rate of return (IRR). This is the cost of equity.
Most analysts assume that dividends will grow forever at a constant rate. This tends to be a low single-digit number between 1% and 4%.
CAPM estimates the cost of equity by adjusting for the risk premium of a company’s stock. It is a little bit easier to calculate than the dividend growth model.
The cost of capital varies across companies and industries due to differences in risk, capital structures, and type of business.