The Weighted Average Cost of Capital is a formula used by investors to calculate the cost of capital for a given firm and tells investors how much value the firm is creating for every dollar spent. The WACC of a company increases with beta and the rate of return on equity. This mean a high WACC comes with more risk and carries less value than a low scoring company.
To find the WACC of a company, multiply the weighted average of the percentage of the company financed through equity and debt by one minus corporate tax rate.
WACC = (E/V)*Re + (D/V)*Rd * (1-Tc)
The investor divides the market value of the firm’s equity (E) by the sum of the equity and debt (V) to calculate the percentage of the firm’s Cost of Equity (Re). This ratio is then used as a weight for the cost of equity to appropriately portion the Cost of Equity in the calculation. The investor then divides the market value of the firm’s debt by the sum of the equity and debt to calculate the weight that is used for the Cost of Debt. This is multiplied by the Cost of Debt (Rd) to give the appropriate portion of debt for the calculation.
The corporate tax rate is then taken out of the calculation to provide the investor with a Weighted Average Cost of Capital that incorporates all sources of a company’s capital structure.
The WACC can be used by the investor to determine whether they will pursue an investment or not. By subtracting the WACC from the stock's return, the investor will know how much value the company is creating for every dollar spent. Suppose that company XYZ has a WACC of 6% and returns of 8%, this would mean that the company adds 2 cents of value for every dollar spent.
Investors may also choose to further their analysis on a company and use WACC as the discount rate in a Discounted Cash Flow model or as a hurdle rate in a Return on Invested Capital (ROIC) analysis. Doing this allows the investor to better consider the company’s capital structure when forecasting the price of a stock.
The WACC is a great tool that investors can use to further their understanding of a company, but it should always be used alongside other metrics. This is because the variables involved are not consistent, which often results in various parties returning contradictory WACC results.
