Weighted Average Cost of Capital - WACC
WACC stands for Weighted Average Cost of Capital. The WACC tell us the minimum % a firm must earn on a project in order to satisfy lenders (Bondholders) and owners (Common Stock Holders).
The WACC consists of Weight of Debt (Wd), Cost of Debt (Kd), and Weight of Equity (We), Cost of Equity (Ks). It is also important to note that a lot of companies have different capital structures, and as such some companies may also have preferred stocks outstanding. For those companies that have preferred stocks outstanding, the formula for WACC would be (Weight of Debt * Cost of Debt*(1-Tax Rate)) + (Weight of Common Stocks * Cost of Common Stocks) + (Weight of Preferred Shares * Cost of Preferred Shares).
The formula above will give you the Weighted Average Cost of Capital (WACC) of the company.
I will give you guys a few basic examples that will help you calculate WACC of a company.
WACC
Calculating WACC - Scenario I
You have been presented with all the variables, and need only to calculate the WACC. This is by far the easiest way to calculate WACC. (Note: The below example doesn't have preferred stocks)
Provided Variables:
Weight of Debt: 60%
Cost of Debt: 10%
Weight of Equity (Common Stock): 40%
Cost of Equity (Common Stock): 18%
Tax Rate: 35%
WACC = Weight of Debt * Cost of Debt (1-Tax Rate) + Weight of Equity * Cost of Equity
= (.6) * (.1)*(1-.35) + (.4) * (.18)
= .111 or 11.1%
So, the Weighted Average Cost of Capital (WACC) in Scenario I was 11.1%
Calculating WACC - Scenario II
Here, you have been provided with Debt-Equity Ratio, Cost of Debt, Cost of Equity, and the Tax Rate. In order to Calculate WACC, you need to find out Weight of Debt and Weight of Equity.
Weight of Debt and Weight of Equity can be found from Debt - Equity Ratio through the formulas
Weight of Debt = (Debt-Equity Ratio) / (1 + Debt-Equity Ratio)
Weight of Equity = 1 / (1 + Debt-Equity Ratio)
Solving the problem:
Listed Variables
Debt-Equity Ratio: .6
Cost of Debt: 10%
Cost of Equity 18%
Tax Rate: 35%
WACC = ?
Step 1: Calculate Weight of Debt and Weight of Equity
Weight of Debt = Debt-Equity Ratio / (1 + Debt-Equity Ratio) = .6/ (1+.6)
Weight of Debt = .375 or 37.5%
Weight of Equity = 1 / (1 + Debt-Equity Ratio) = 1 / (1 + .6)
Weight of Equity =.625 or 62.5%
Step 2: Calculate WACC
WACC = Weight of Debt * Cost of Debt (1-Tax Rate) + Weight of Equity * Cost of Equity
WACC = (.375) * .1(1-.35) + (.625) * (.18)
WACC = .136875
WACC = 13.69%
In the above example we got Weighted Average Cost of Capital as 13.69%
Calculating WACC - Scenario III Preferred Stocks
In Scenario 3, you have been presented with all variables, but this time around, the WACC calculation includes Preferred Stocks.
Listed Variables:
Tax Rate : 40%
Cost of Common Stock: 13.9%
Cost of Preferred Stocks: 5.8%
Cost of Debt: 6.40%
Weight of Common Stock: 63.93%
Weight of Preferred Stock: 6.61%
Weight of Debt: 29.46%
WACC = Weight of Debt * Cost of Debt (1-Tax Rate) + Weight of Common Stocks * Cost of Equity + Weight of Preferred Stocks * Cost of Preferred Stocks
WACC = 29.46% * 6.40% (1-40%) + 63.93% * 13.9% + 6.61% * 5.8%
WACC = 10.40%
All the 3 listed above examples are very basic calculations for WACC. I will list more complex examples of WACC Calculations in the near future.
Also, in the above examples we assumed that we knew how to calculate or were given the Cost of Equity, Cost of Debt, Cost of Preferred Stocks, and as such. In later sections, I will also explain how to find Cost of Equity, Cost of debt, Cost of Preferred Stocks, Weight of Common Stocks, Weight of Bonds, and Weight of Debt.
WACC - Weighted Average Cost of Capital
WACC Calculation - Intermediate Problems
Bond Valuation
Back to Indews Broadcast
Good introduction about WACC.Worth understanding the different scenarios.
In another scenario, what would be the WACC for XXX company? Details below.
XXX Corporation’s current sales are R2 000 000 per year, consisting of fixed costs of R500 000 and variable costs of 35% of sales. The company aims at increasing its sales and intends expanding its production capacity by investing R900 000 in a new plant and machinery.
It is company policy to finance 60% of its total financing needs with equity and 40% with debt. At present 50 000 shares have been issued and trade at R50 each, while the company pays R200 000 interest per year on debentures with a yield of 12%. The company’s investment banker also provided the following information:
- the average return on equity is 8%.
- flotation costs will be 10%.
- the dividend growth rate is expected to be 6%.
- the dividend cover is maintained at 4 times.
- FUN4U’s marginal tax rate is 40%.
REQUIRED
(a) Calculate FUN4U’s current retained earnings.
(b) Identify the forms and amounts of new financing required for the proposed investment.
(c) Calculate the weighted average cost of capital (WACC) that should be used in the evaluation of the new investment.
(d) Indicate how many new ordinary shares should be issued.
Hi
I noticed the notation in reference to the exclusion of preferred stocks. What if the listed variables had included preferred stock and it cost in a percentage? How would that effect the debt/equity ratio? How would that effect the calculation of the weights for WACC?
If Preferred Shareholders are also contributors of capital to the company, you add their share as well.
For Example.
Company A's capital contributors include Common Stock holders with a required return of 15%, and comprise 50%, Preferred Stock holders with a required return of 12% and comprise 10%, and Debt holders with a required return of 10%.
The WACC Formula would be
(Weight of CS * CS Required Return + Weight of P.S. * Required Return + Weight of Debt * Required Return)
When you have preferred stock holders, you simply add their cost of return times their weight.
The effect of Preferred Stock (P.S) would depend on the weight and required return demanded by preferred stock holders.
Your blog is wow, especially on WACC model. You made me learn the basics in minutes. Thanks
Well, I am glad you found it to be helpful.