Businesses often use the weighted average cost of capital (WACC) to make financing decisions. The WACC focuses on the marginal cost of raising an additional dollar of capital. The calculation requires weighting the proportion of a company's debt and equity by the average cost of each funding source.
Calculating the weight of debt and weight of equity
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The total amount of equity and total amount of debt are reported on a firm's balance sheet.
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Weight of Debt = total debt / (total debt + total equity)
Weight of Equity = total equity / (total debt + total equity)
Finding the cost of debt
The cost of debt is the long-term interest a firm must pay to borrow money. This is also referred to as yield to maturity. The formula for WACC requires that you use the after-tax cost of debt. Therefore, you will multiply the cost of debt times the quantity of: 1 minus the firm's marginal tax rate.
Finding the cost of equity
Finding the firm's cost of equity requires knowing the risk-free rate of interest in the market, the firm's value of Beta, and a measure of the current market risk premium. The risk-free rate is typically considered to be the interest rate on short-term Treasuries. A firm's Beta is a measure of its overall risk compared to the general stock market. Many websites that provide free company financial information report this value for publicly traded firms. If you cannot find this for a particular firm, you can also use an industry average value of Beta. The market risk premium generally falls between 3 and 5 percent, but that number can be adjusted up or down to consider current market conditions.
Cost of equity = risk-free rate + (Beta x market risk premium)
Calculating the WACC
WACC = [weight of debt x cost of debt x (1 - tax rate)] + (weight of equity x cost of equity)
Example
Suppose a company has $1 million in total debt and equity and a marginal tax rate of 30%. It currently has $200,000 in debt with a 6% cost of debt. It has $800,000 in total equity with a Beta value of 1.10. The current Treasury Bill rate is 2%, and the market risk premium is 5%.
weight of debt = $200,000/$1,000,000 = 0.20
weight of equity = $800,000/$1,000,000 = 0.80
cost of equity = 2% + (1.10 x 5%) = 7.5%
WACC = [0.20 x 6% x (1-.30)] + (0.80 x 7.5%)
So, the WACC is 6.84%.