Understanding the weighted average cost of capital

The cost of capital is a key factor in choosing the mixture of debt and equity used to finance a firm. Most firms employ several capital components such as common or preferred stocks, along with debt in order to finance their investments and provide a return on their investments to their shareholders.  

If a firm has only common stocks, then the cost of capital is the required return on equity. However, as most firms employ different types of capital components, the required rates on return are different due to differences in risk. Therefore, the cost of capital should be calculated as a weighted average of the various components’ costs in order to reflect the average riskiness of all the firm's assets from raising new debt in the planning period. This weighted average is the Weighted Average Cost of Capital (WACC). 

Analyzing the WACC components

Weighted Average Cost of Capital (WACC) is calculated using the firm's target capital structure together with its after-tax cost of debt, cost of preferred stock, and cost of common equity.  

Weighted Average Cost of Capital (WACC) can be calculated as follows:

WACC = WdRd(1-T) + WpsRps + WceRs 

where:

•Wd: the weight of debt = the target proportion of debt

•Wps: the weight of preferred stocks = the target proportion of preferred stocks

•Wce: the weight of equity = the target proportion of equity

The percentages (weights) of each capital component are based on the firm’s optimal capital structure. 

•Rd(1-T): after-tax cost of debt = it is the rate of return that debt holders require and it is calculated after tax because interest is deductible.

•Rps: cost of preferred stock = if the firm issues preferred stocks, then Rps is included in the WACC calculations, but without tax adjustments. Firm bears their full cost.

•Rs: cost of common equity = it is the rate of return on the equity raised either through the issue of new shares or through retaining earnings. Normally, the cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which takes into consideration that risk free rate (RRF), the expected market risk premium (RMP) and the beta (b) coefficient of the firm’s stock. 

Example

We need to calculate the WACC of firm X assuming that the firm does not issue preferred stocks. Therefore, the component WpsRps of the formula equals zero.  

Calculations 

Rd(1-T) = Cost of Debt * (1- Tax) = 6.50% * (1-30%) = 4.55%

Rs = Rs = RRF + (RPM * b) = 5.00% + (5.80% * 0.59) = 8.42%

Wd = (Short-term Debt + Long-term Debt) / (Book Value of Debt + MVA of Common Equity) =

650,250 / 5,586,700 = 11.64%

Wce: MVA of Common Equity / (Book Value of Debt + MVA of Common Equity) =

4,936,500 / 5,586,700 = 88.36% 

Plugging in our calculations in the formula we derive that the WACC for firm X is: 

WACC = (11.64%)*(4.55%) + 0 + (88.36%)*(8.42%) = 0.53% + 7.44% = 7.97%

This means that the weighted average cost the firm would face for a new, marginal dollar of capital is almost 8%.  

Factors to be considered

There are several factors that are beyond a firm’s control when calculating the WACC. These are the interest rates, the market risk premium and the taxes. All three factors affect the cost of debt and the cost of equity. For example, if interest rates rise, the cost of debt increases because the firm would have to pay the bond holders a higher interest rate to obtain debt capital. Similarly, if taxes increase, then cost of debt increases since tax percentage is used in the WACC calculations. Also, in regards to expected market risk premium, it is determined based on the risk aversion of the shareholders.  

On the other hand, there are factors that a firm could control such as its capital structure policy, its dividend policy and its investment policy. All three policies aim to adjust for differences in project risk. 

In conclusion, the Weighted Average Cost of Capital (WACC) is a factor to estimate a firm’s value in order to achieve effective strategic decision making and performance evaluation by calculating a firm's cost of capital that weights each capital component proportionately. Failing to adjust for differences in project risk would lead a firm to undertake value-destroying projects and reject value-adding projects. Over time, the firm would become riskier, its WACC would increase and its shareholder value would decline.