Weighted Average Cost of Capital (WACC) is defined as the minimum return that a company must generate to satisfy its owners, creditors, and other providers of capital or else it would make more sense for them to invest elsewhere. Since there are different components that make up a company’s overall capital, each possibly with a different cost associated with them, this method blends them into an overall cost, proportionally weighting each component based on its size.
Let’s look at a simple analogy first. Suppose we are interested in determining how much a bag of mixed nuts cost. Peanuts make up 60% of the bag and cost $1.99 / lb. Almonds are just 20% of the mix but cost $3.99 / lb. The final 20% of the bag is Macadamia nuts at a cost of $5.99 / lb. How much does 1 pound of mixed nuts cost? We have all the information we need to answer this question. We know the relative percent, or weight, carried by each component and we also have a cost for that component. To arrive at the blended cost we simply multiply each component weight by the component cost and add them together:
(60% x 1.99) + (20% x 3.99) + (20% x 5.99) = $3.19
Our bag of mixed nuts costs $3.19 / lb. Simply right? Now let’s apply this to a company, except this time instead of three types of nuts we have three forms of capital, and instead of having fixed dollar amounts we have interest rates for each type of capital. Our goal is to assign weights to each type of capital and come up with a blended, or weighted overall cost of capital for the company – hence the name Weighted Average Cost of Capital!
There’s are up to three components of the capital structure of a company:
- Equity: The capital owned by the stockholders of the company.
- Debt: Capital that is borrowed from another party by the company, such as bonds, loans and commercial paper.
- Preferred Stock: Somewhat of a hybrid of both equity and debt, but which usually pays a dividend and has priority over common stockholders to assets and earnings in the event of liquidation.
I say up to three components because not all companies have debt, and not all companies issue preferred stock. Now that the types of capital have been identified, we now need to determine the cost of each. Unfortunately it’s not quite as simple as our bag of nuts example, but there are some straightforward calculations to help us.
Cost of Equity
The Cost of Equity for a company is defined by the following equation:
CoE = rf + Ba x (rm – rf)
- rf is the risk free rate of return
- Ba is the stock’s beta
- rm is the market’s overall long term expected rate of return
Typically, the current yield on long term US Treasury Bonds is used to represent the risk free rate of return. These are considered to be the safest investments there are and while not technically risk free, they’re pretty close. Current yields can be found on Yahoo Finance, and as of today’s writing the 10 year treasury bond was yielding 1.84%.
Beta measures the correlated volatility of a stock, or in simpler terms is a measure of how closely the stock follows the price movements of the general market. For example, if the overall market moves up by 1% and the stock also moves up in price by 1%, then the stock has a beta equal to 1 because it moved in the same direction and by the same amount. If the stock were only to move up 0.5% however, then the beta would be 0.5. Beta can be found on most stock research sites, for example at msn money. Note that beta is calculated over a long period of time (usually 2 years), and if different timeframes are used, the beta value will differ accordingly. This is why the beta value for a stock might be slightly different depending on the source. For our simple example, let’s assume that the company has a beta of 1.2, which means that it is slightly more volatile than the general market.
The expected return of the overall market is often the subject of debate, but typically historical data over the past X number of years is used under the assumption that this rate of return will hold true for the future. According to this article on Wikipedia, the average compounded annual return for the S&P 500 market index was 8.2% over the past 60 years.
We can now plug these numbers into our hypothetical example:
CoE = 1.84% + 1.2(8.2% – 1.84%) = 9.5%
The cost of equity for our company is 9.5%.
Cost of Debt
We’ll now look at debt. The cost of debt is simply the current market rate that the company is paying for the debt on its balance sheet. Companies get a tax credit for interest paid on debt however, so the net cost of debt is actually the debt paid less the tax savings on the interest paid, defined by the following equation:
Net Cost of Debt = Cost of Debt x (1 – tax rate)
A company’s effective tax rate can usually be found in it’s most recent financial statements or annual report. For this example we’ll assume a tax rate of 35%. The cost of debt we’re looking for however is a little harder to come by. What we’re after is the effective interest rate for the company’s combined debt such as bonds, loans, and commercial paper. This is not usually public knowledge however and must be approximated. The easiest way to do this is to look up the company’s credit rating and then use the yield for a long term corporate bond. Credit ratings for most companies can be found on the Standard & Poors website. Let’s assume a credit rating of AA for our fictitious company. We once again can go to Yahoo Finance and find that the 20 year yield for a AA corporate bond is listed at 3.68%. Remember that we want the net cost of debt post-tax however, so we plug the numbers into the above equation:
Net Cost of Debt = 3.68% x (1 – 0.385) = 2.26%
Cost of Preferred Stock
Not all companies issue preferred stock, but when they do it should be treated separately from debt because it usually carries a higher cost due to the fact that debt holders have a higher priority over preferred stock holders in the event of liquidation. The cost of preferred stock can be calculated as follows:
CoPS = D / P
- D is the current annual dividend paid for the preferred stock
- P is the current price of the preferred stock
For this example, let’s assume that the company pays $8 / share for it’s preferred stock, and preferred shares currently sell for $120 / share. This equates to a cost of 6.6% for preferred stock.
Calculating the Weighted Average
Now that we have a cost associated with each component of the company’s capital structure, we can assign weights and calculate a weighted average of the total cost of capital. We do so by means of the following weighted average equation – again, exactly the same idea as the mixed nuts example:
WACC = (% equity) x (cost of equity) + (% debt) x (cost of debt) + (% preferred) x (cost of preferred)
Let’s assume that the capital structure of the company is such that 60% of the company’s value is equity, 35% debt, and 5% preferred stock. We now have the following information:
- 60% equity at a cost of 9.5%
- 35% debt at a cost of 2.26%
- 5% preferred stock at a cost of 6.6%
Plugging all of these numbers into the above equation results in a WACC of 6.82%.