Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC) is a calculation to determine a company's cost of capital. Let me start by examining what this means. A company can get its funding from two sources, a lender (traditionally a bank) known as Debt or from owners/investors, known as equity. If a company is 100% debt funded at 10% then the cost of capital is 10%. If a company is 100% equity funded at 15% then the company's cost of capital is 15%.
If the company is 50% equity, 50% debt funded then using the above example then the company's cost of capital is 12.5%.
So where is the Problemo?
The problem occurs when a company is funded by debt and equity and the split between the two funding streams is not equal. It is at this point where we need to use a WACC to determine a company’s cost of capital.
In the following example we may be 60% debt funded and 40% equity funded. To perform the calculation I need to bring in one further complication, the company tax rate. The company tax rate relates to the calculation of Debt, this is because interest expense on debt is a tax-deductible expense for the company. The government allows you to write the expense off against your income. For the purposes of demonstration I will use the Australian Company taxation rate of 30% in the example.
So the formula to calculate WACC is as follows;
Debt Proportion x Cost of Debt % x (1 – Tax Rate %) + Equity Proportion x Cost of Equity %
So gathering all of the information from above.
Cost of Debt %=10%
Tax Rate %=30%
Cost of Equity %=15%
In Excel the formula
WACC =0.60 * 0.10*(1-0.30) + 0.40 * 0.15
A company can use the above WACC rate when determining whether to go ahead with a project. If for example a project is expected to return 8% then the project would NOT go ahead because the expected return is less than the cost of debt. A project would have to achieve a rate greater than 10.20% in order to consider the project.