How to Calculate Weighted Average Cost of Capital (WACC)

Most businesses run their operations with borrowed money. To fund their work, companies use two primary sources of capital: equity and debt. Equity means raising money by selling preferred stock and common stock to shareholders. Debt means selling bonds or taking out commercial loans.

When investors decide whether to buy a business, they want to make sure that it can be profitable. That’s why they need to consider how much money a company spends and how much money it brings in.

One metric that many investors use to see if a company is worth buying is the weighted average cost of capital (WACC). This metric helps investors measure a company’s costs based on its capital structure.

Below is the formula for figuring out a business’s WACC.

‍

• E: Market value of the firm’s equity
• D: Market value of the firm’s debt
• V: Combined equity and debt
• Re: Cost of equity
• Rd: Cost of debt
• Tc: Corporate tax rate

Deciphering this formula can be fairly confusing unless you are very familiar with accounting. This article explains what WACC is, what its various parts are, what it’s used for, and how to calculate it for a business.

• What is the weighted average cost of capital (WACC)?
• What is WACC used for?
• What is the WACC formula?
• What are the 3 main factors to consider when measuring WACC?
• What is a normal WACC number?

What is the weighted average cost of capital (WACC)?

A company’s WACC is the percentage of money, per every dollar, that it spends on the assets it uses to stay in business. In a business’s WACC score, the costs of each type of capital–equity and debt–are weighted proportionately because the company’s debt and equity might have different amounts and different interest rates.

People generally understand that companies must pay back any debt they’ve incurred, including making interest payments. What’s less understood is that companies also must pay back their shareholders; this happens in the form of dividends. Generally, if shareholders don’t see high enough returns, they’ll invest their money in a different company.

As an example, let’s consider a company with capital assets that total $500,000. It has $200,000 in debt (in bonds) and $300,000 in equity. The company has to pay back the bonds with a 4% interest rate. The company also has to pay back its shareholders, who provided equity, by giving them an expected return of 9%.

Note: The example uses random percentages to represent possible loan interest rates (4%) and investor expected returns (9%). The numbers for your business are likely to be different. Your loan might have a higher or lower interest rate than 4%, and your investors might expect returns of more or less than 9%.

What is WACC used for?

Investors use the WACC formula in several ways:

• WACC is used to calculate net present value (NPV). NPV is a way of measuring how much value an investment in a company will generate over a given period.

• Firms can use WACC as their opportunity cost when evaluating investment opportunities. When a firm invests in a business, it needs the return on its investment to be large enough to make up for the business’s WACC.

• Companies can use WACC as a hurdle rate in the valuation of mergers and acquisitions (M&A). Any M&A a business takes part in needs to create enough value to offset any new costs of doing business.

What is the WACC formula?

We’ll break down the WACC formula and show you how to use it in the next few sections.

WACC = [(E/V) * Re] + [(D/V) * Rd * (1 - Tc)]

Elements of the formula

Here are the elements in the WACC formula and what they represent:

• E: Market value of the firm’s equity
• D: Market value of the firm’s debt
• V: Combined equity and debt
• Re: Cost of equity
• Rd: Cost of debt
• Tc: Corporate tax rate

Breaking down the elements

Now, we’ll explain what each element in the formula means.

• E: The market value of a firm’s total equity (E) is the value of all the shares of a company combined. This is also known as market capitalization (market cap).

• D: The market value of a firm’s debt (D) is the amount that investors would be willing to pay to buy that debt. It’s not always the same as debt book value, but it’s usually close to it.

• V: V is the total amount of equity and debt that a company has.

• Re: The cost of equity (Re) is the required rate of return that a company needs to maintain to keep its investors.

• Rd: The cost of debt (Rd) is the interest expense that a company pays on a loan or bond.

• Tc: The corporate tax rate (Tc) is the tax rate a business must pay to the government.

Using the WACC formula

The WACC formula can appear daunting at first glance. The best way to understand how to use it is by breaking it up into equity and debt.

‍

The market value of your equity (E) divided by your total capital (V) gives you the percentage of your business capital made up of equity. You multiply it by the cost of your equity (Re) to get the weighted cost of your company’s equity for every dollar it earns.

‍

The market value of your debt (D) divided by your total capital (V) gives you the percentage of your business capital made up of debt. Multiply your percentage by the cost of your debt (Rd) to get the weighted cost of your debt for every dollar your company earns.

The cost of your debt is the interest rate you have to pay on your debt (Rd) times the corporate tax benefit (1 - Tc). The debt is decreased by the corporate tax benefit because businesses can typically deduct debt interest from their taxes.

Finally, you add the two numbers together to get your WACC.

Let’s apply the WACC formula to a company. Your firm is trying to decide whether to buy an e-commerce software company. The company has $100,000 in total capital assets: $60,000 in equity and $40,000 in debt. The cost of the company’s equity is 10%, while the cost of the company’s debt is 5%. The corporate tax rate is 21%.

First, let’s calculate the weighted cost of equity.

[(E/V) * Re]

[(60,000/100,000) * 0.1] = 6%

Then, we calculate the weighted cost of debt.

[(D/V) * Rd * (1 - Tc)]

[(40,000/100,000) * .05 (1 - 0.21)] = 1.58%

Finally, we add the percentages together.

WACC = 7.58%

This means that the e-commerce company will spend 7.58% of every dollar that it earns on its capital assets, on average.

If the WACC formula still seems confusing to you, Upwork can connect you to freelance financial analysts who understand it. Find the money experts who can help your business make sound investments.  

What are the 3 main factors to consider when measuring WACC?

Before you can use the WACC formula, you’ll need to know a few numbers. You’ll have to figure out the:

• Market values for the debt and equity of a company
• Cost of that debt and equity
• Corporate tax rate

Market values of debt and equity

The WACC formula deals with the market values of a company’s debt and equity. The market value of a company’s debt generally won’t stray too far from the book value of its debt. It’s typically OK to substitute the book value of a business’s debt for the market value in a WACC calculation. You can find the book value of a company’s debt on the balance sheet.

Equity is a different story. The book value of a company’s equity represents the amount of money split among all business shareholders if the company is liquidated. The market value of a business’s equity (market cap) is the combined worth of all the company’s shares in the market.

To calculate a company’s market cap, multiply the current stock price of one of its shares by the total number of outstanding shares that the company has.

For example, if a company has 1,000,000 outstanding shares in the market and a single share price of $20, the total market cap of the company is $20,000,000.

Costs of debt and equity

The cost of a business’s debt is simply the amount of interest the company has to pay on a loan or bond. For example, if a company gets a $3,000 loan from the bank with a 5% interest rate, the cost of debt for that loan is 5%.

The cost of a company’s equity is much harder to calculate. The process for determining the cost of a business’s equity is called the capital asset pricing model (CAPM). Here’s the formula and what each element means:  

‍

• Re: Cost of equity
• Rf: Risk-free rate
• β: Equity beta
• Rm: Annual return of the market

The risk-free rate (Rf) is the rate of return that an investor expects from an investment over a period of time that has absolutely no risk. For example, the risk-free rate for a stable U.S. treasury bond is around 2% over 10 years.

The equity beta (β) measures the risk level of a particular security compared to the rest of the market or an index like the S&P 500. If the beta equals 1, the security follows the market exactly. For example, if the market loses 2%, the security loses 2%. A higher beta indicates a higher risk for a stock. (To estimate beta, you can use an online calculator).

The annual return of the market (Rm) is the expected yearly rate of return in the market where stock is traded, given the market’s historical rates of return.

Let’s say you’re trying to calculate the cost of equity for an online computer retailer. The company has stock shares that trade on the S&P 500. The stock has a beta of 2. The market annual rate of return is 6%. And the risk-free rate on a treasury bond is 2%. Here’s how you’d calculate the company’s cost of equity.

Re = Rf + β * (Rm - Rf)

Re = 2 + 2 * (6 - 2)

Re = 10% ​

‍

Note: Even though the actual risk-free rate for a government bond over 10 years is not exactly 2%, the rate has been rounded to 2% in the above example to simplify the equation. Be aware that risk-free rates for government bonds change over time. You should do your own research to figure out what the current rates are before using the CAPM model for an actual business.

Corporate tax rates

Before using the WACC formula, you should be aware of the current corporate tax rate in your location. In 2018, the corporate tax rate in the United States was lowered to 21%, but it can change periodically.

What is a normal WACC number?

A low WACC number usually makes a company more attractive to investors. A company’s WACC number is the percentage of all the money it earns that it needs to spend on its capital assets. That means a company with a lower WACC score spends less on its capital assets, so a higher percentage of its earnings are pure profit.

A higher WACC score means that a larger percentage of a business’s income is being used to pay for its assets. A business that spends more on its capital assets needs to generate more revenue to offset the cost of those assets.

If you plan to calculate WACC for a possible investment, you should know that it has limitations. WACC is a predictive model that uses market trends to measure a company’s cost of equity.

WACC doesn’t consider events that can alter the market, such as natural disasters and conflicts. There’s also no guarantee that a company will have continued profitability even if it has performed well in the past.  

Get help evaluating investment opportunities

If you’re looking to invest in new projects or businesses, the WACC formula can help you decide which opportunities are promising.

If you’re a business owner, Upwork can help your small business find freelance financial analysts with the expertise to guide you in the right direction so that your investments have a better chance of being fruitful.

Are you a financial expert with the knowledge to help businesses evaluate their investment opportunities or financial statements? Let Upwork help you find the best projects for you. Explore available freelance financial analyst jobs today.