Calculation and Interpretation of Weighted Average Cost of Capital (WACC)

The concept of cost of capital informs the investment decisions that a company’s management makes. Similarly, it is useful in the valuation of a company by investors and analysts. A company that invests in a project that produces a return greater than its cost of capital has created value. It is imperative to note that a return that is less than the cost of capital destroys value.

Cost of Capital

The cost of capital is not observable but must be estimated using assumptions. It is the rate of return which suppliers of capital, i.e., bondholders and owners require as compensation for their capital contribution.

Marginal cost is the cost of raising additional funds for a potential investment project. An investment analysis is most concerned with the cost of capital.

Weighted Average Cost of Capital

The cost of capital for a company refers to the rate of return that investors demand. It is the average-risk investment of a company. It is usually estimated by computing the marginal cost of each of the various sources of capital for a company and then taking a weighted average of these costs. This is referred to as the weighted average cost of capital (WACC). Given that it is the cost that a company incurs to raise additional capital, the WACC may also be referred to as the marginal cost of capital (MCC).

The formula for the WACC is:

$$ \text{WACC}={ w }_{ d }{ r }_{ d }\left( 1-t \right) +{ w }_{ p }{ r }_{ p }+{ w }_{ e }{ r }_{ e } $$

Where:

w_d = The proportion of debt that a company uses whenever it raises new funds.

r_d = The before-tax marginal cost of debt.

t = The company’s marginal tax rate.

w_p = The proportion of preferred stock that the company uses when raising new funds.

r_p = The marginal cost of preferred stock.

w_e = The proportion of equity that the company uses when it raises new funds.

r_e = The marginal cost of equity.

Example: Calculating the WACC

Assume that company XYZ has the following capital structure: 25% equity, 10% preferred stock, and 65% debt. Its marginal cost of equity is 12%, while its marginal cost of preferred stock is 9%. Lastly, its before-tax cost of debt is 7%. If the marginal tax rate is 35%, what is the WACC of company XYZ?

In this example, w_d = 65%, r_d = 7%, t = 35%, w_p = 10%, r_p = 9%, w_e = 25%, and r_e = 12%.

And we know that,

$$ \text{WACC}={ w }_{ d }{ r }_{ d }\left( 1-t \right) +{ w }_{ p }{ r }_{ p }+{ w }_{ e }{ r }_{ e } $$

Therefore,

$$ \begin{align*}
{\text{company XYZ’s WACC}} & = (0.65)(0.07)(1-0.35) + (0.1)(0.09) + (0.25)(0.12) \\
& = 0.02958 + 0.009 + 0.03 \\
& = 0.06858 = 6.858\% \\
\end{align*} $$

Question

What is the weighted average cost of capital for a company if it has the following capital structure: 30% equity, 20% preferred stock, and 50% debt? Its marginal cost of equity is 11%, its marginal cost of preferred stock is 9%, its before-tax cost of debt is 8%, and its marginal tax rate is 40%.

A. 7.84%.

B. 7.50%.

C. 8.00%.

Solution

The correct answer is B.

\(\text{WACC}={ w }_{ d }{ r }_{ d }\left( 1-t \right) +{ w }_{ p }{ r }_{ p }+{ w }_{ e }{ r }_{ e }\)

\(\text{WACC} = (0.50)(0.08)(1-0.40) + (0.2)(0.09) + (0.30)(0.11) = 7.5\%\)