How to Calculate WACC (With Variables and Formula)
By Indeed Editorial Team
Published April 20, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
The weighted average cost of capital (WACC) helps companies make business decisions. The WACC determines the risk and potential return of company projects. Understanding how to calculate WACC can help determine a company's operations and project costs. In this article, we discuss the importance of calculating WACC, explain the factors that may affect WACC, provide steps on how to calculate WACC, and outline an example.
Why knowing how to calculate WACC is important
Knowing how to calculate WACC helps shareholders and companies make investment decisions. WACC identifies the minimum rate a company pays its shareholders and investors for financing its projects. It assesses the cost of capital for any project. Capital includes the company's financial assets.
Companies typically use equity, debt, and preferred stock to raise capital. They can obtain debt capital through loans and raise equity capital by selling company shares. Preferred stock is a type of share that receives higher dividends and has a higher claim to company assets. WACC helps financial analysts understand a company's financial performance. Here are some other reasons why calculating WACC is important:
WACC may represent a company's opportunity cost for engaging in specific projects. A company may use WACC to measure the hurdle rate of a merger, acquisition, or project. The hurdle rate is the minimum return investors require for providing funding for a project. If the hurdle rate is too expensive, a company may decide not to engage in the project. For example, a potential project that can produce a higher return than the cost of the capital may be a viable choice for the company. WACC helps managers and executives make quick decisions without halting company activities.
Determines company value
WACC is an excellent way of determining how much value a company produces for its investors. A low WACC typically indicates a successful business that can attract investors at a low cost. A high WACC value may indicate that investing in the company is risky and they may compensate investors with higher returns. Investors usually conduct investigations into a company's valuation before investing. They use the company's financials to predict its cash flows and determine its financial standing.
Compares business risks
Executives can use WACC to compare the risks involved in different projects or business ventures. A risk-adjusted WACC is a return value that companies calculate and modify to match the business risk of a new project that's different from the company's previous ventures. WACC helps investors make decisions on projects to fund, depending on the risk.
Variables that affect WACC
Variables that may affect the calculation of WACC include:
Economic conditions can affect the cost of capital. If the economy is growing, the price of obtaining a bank loan may be significantly lower. Investors may also be more willing to raise capital as their interest increases. Calculating WACC with predicted growth rates of the economy ensures its accuracy.
If corporate tax decreases, WACC reduces. If corporate tax increases, a company's cost decreases because corporate taxes and operation costs are tax-deductible. The interest on loans a company receives is tax-deductible.
Interest rates play a significant role in determining WACC. The interest rate is the amount the lender charges the borrower; it's the cost of the loan. Interest rates may positively or negatively affect the risk-free rate. The risk-free rate is the interest that investors expect from a risk-free investment. Company executives use a risk-free rate to calculate WACC. A higher risk-free rate increases WACC. Changes made to the interest rate may also affect the cost of debt financing. If the interest rate falls, the cost of debt financing reduces.
A company's dividend policy is the structure it uses to pay dividends to shareholders. If the dividend ratio is high, it may reduce the retained earnings available to the company. Retained earnings are the profits a company uses to fund operations and projects. Reduced retained earnings may increase the need for external funds, loans, and shares. It affects the variables a company uses to calculate WACC. The dividend policy also affects a company's value, which impacts WACC and investors' willingness to fund the company's projects.
WACC vs. IRR
The internal rate of return (IRR) is an investment analysis technique that companies use to determine the return a project can yield. IRR and WACC are linked because they contain similar components. IRR analyzes and predicts the profitability of company projects. A low WACC signifies minimal financing costs and risks, and it indicates the poor financial performance of a company. An IRR analysis recommends any project that has an IRR greater than the company's capital cost. If IRR is lower than the capital cost, a company might not accept the project.
How to calculate WACC
Here are the steps you can follow to calculate WACC:
1. Define the equity and debt market values
Determine the market values for the debt and equity of a company. The company's debt may include bonds and loans. The market value of debt explains the price that investors are willing to pay for the company's debt. It differs from the book value of debt, which is the total amount the company owes. The market value of equity shows the company's value in the stock market. You can calculate it by multiplying the current market price of the company's shares by its outstanding shares. These market values of debt and equity are components of the WACC formula.
2. Identify the actual costs of equity and debt
Analyze assets, liabilities, and capital costs to determine the actual cost of debt. A company can evaluate the total interest it pays on its debt and use this to determine the after-tax cost of debt. Calculating the cost of equity is more technical; a company might use the dividend capitalization model to calculate the cost of equity. A company uses this formula if it pays dividends. It may also use the capital asset pricing model (CAPM) to determine the cost of equity.
Using this model, the cost of equity formula is:
Cost of equity = (dividends per share for the upcoming year / current market value) + growth rate of dividend
3. Combine the debt and equity values
Combine the market values of debt and equity with the actual cost. This value is an essential component of the WACC formula. For example, if the market value of debt and equity is $30,000 and the actual cost is $40,000, you combine these values for a variable of $70,000.
4. Understand the corporate tax rate
Identify the tax rate that applies to a company. A company's tax rate may vary due to deductions and other factors. The tax rate typically appears in a percentage format that you can convert to a decimal figure before using it in the WACC formula. For example, a company that pays 20% corporate tax converts this value to 0.2 before inputting it into the formula.
5. Use the WACC formula
The WACC calculation formula can be complex due to its various components. Some companies use online WACC calculators to replace the formula.
The formula for calculating WACC is:
WACC = [(equity market value / total market value of the company's debt and equity) - equity cost] + [(debt market value / total market value of the company's debt and equity) - debt cost - (1 - current corporate tax rate)]
Example of calculating WACC
Here's an example of how a company can calculate its WACC to determine its risk and financial performance:
Greenhouse is a construction company that wants to build some new properties. It wants to raise capital by issuing shares and bonds to potential investors. It also intends to apply for a bank loan to finance the project. Calculating the WACC helps it understand the cost of attracting investors and the return these investors may expect from the project. This also shows investors the business risk of financing Greenhouse's project.
Greenhouse's financial analysts can analyze its financial data and use this to calculate WACC. The analysts identify the market values and actual costs of Greenhouse's debt and equity. They also estimate the investment and capital risks. They apply the appropriate corporate tax rate and convert it to a decimal figure. Assuming these figures, the analyst inputs these values and uses the formula to calculate WACC:
E = 30,000
Re = 70,000
D = 50,000
V = 110,000
Rd = 80,000
Tc = 30%
WACC = [(30,000/110,000) - 70,000] + [(50,000/110,000) - 80,000 - (1 - 0.3)] = (19,090) + (25,454) = 44,544
This means that Greenhouse's weighted average cost of capital is $44,544.
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