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.

Debt Proportion=60%
Cost of Debt %=10%
Tax Rate %=30%
Equity Proportion=40%
Cost of Equity %=15%

In Excel the formula

WACC  =0.60 * 0.10*(1-0.30) + 0.40 * 0.15

WACC=10.20%

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.