How to Calculate the Weighted Cost of Capital

Cost of capital fluctuates depending on market forces.

The weighted average cost of capital, or WACC, of a company represents the proportional cost that it pays to raise debt or equity financing. The cost of debt is the interest rate that a company pays for loans and bonds. The cost of equity is the expected return that investors receive for investing in the company's stock. Debt is generally less risky; therefore its cost tends to be lower than the cost of equity. Interest expense is tax-deductible, so the cost of debt is adjusted by the company's effective tax rate.

Things You'll Need

• Calculator

Instructions

1. Find the amounts and costs of debt in a company's financial statements. These costs, or interest rates on loans and bonds, will be located in the footnotes that follow the income statement and balance sheet in an annual report or in a 10Q report.

2. Write down the loans and bonds that the company has, with the interest rates next to each one. For example, it might look like this, converting the rates to decimals:

   $100,000 .05 (for 5 percent)

   $200,000 .06 (for 6 percent)

   $300,000 .07 (for 7 percent)

3. Find the amount of equity that the company has. Look at the balance sheet. At the bottom of the equity and liabilities section there should be a number for total shareholder's equity.

4. Add this number below the debt numbers. Let's say it's $400,000:

   $100,000 .05

   $200,000 .06

   $300,000 .07

   $400,000

5. Estimate the expected return that a shareholder might expect for an annual investment in the company's stock. This is highly subjective, but for the purpose of this example, use 10 percent and write it down next to the equity amount.

6. Figure the effective tax rate of the company by dividing the tax expense number into the pre-tax income number. Find both of these on the company's income statement.

7. Subtract the effective tax rate from 1 to get the tax effect factor for the debt. For example, if the effective tax rate is 30 percent, then 1 minus 30 percent = 70 percent. Write this down next to the debt numbers as a decimal, or .70.

8. Multiply across the table as follows:

   $100,000 5 percent .70 3,500

   $200,000 6 percent .70 8,400

   $300,000 7 percent .70 14,700

   $400,000 10 percent 0 40,000

9. Add up the numbers in the column on the right to get 3,500+8,400+14,700+40,000 = 66,600.

10. Add up the dollar amount in the far left column like this: 100,000+200,000+300,000+400,000=1,000,000.

11. Divide 66,600/1,000,000 to get 0.067, or 6.7 percent. This is the WACC of the hypothetical company.

References

• ValuePro: The Cost of Equity
• Value Based Management: Weighted Average Cost of Capital
• Wacccalculator.com: WACC Calculator