The weighted average cost of capital is the average interest rate a company must pay to finance its assets. As such, it is also the minimum average rate of return it must earn on its current assets to satisfy its shareholders or owners, its investors, and its creditors.
Weighted average cost of capital is based on the business firm's capital structure and is composed of more than one source of financing for the business firm; for example, a firm may use both debt financing and equity financing. Cost of capital is a more general concept and is simply what the firm pays to finance its operations without being specific about the composition of the capital structure (debt and equity).
Some small business firms only use debt financing for their operations. Other small startups only use equity financing, particularly if they are funded by equity investors such as venture capitalists. As these small firms grow, it is likely that they will use a combination of debt and equity financing. Debt and equity make up the capital structure of the firm, along with other accounts on the right-hand side of the firm's balance sheet such as preferred stock. As business firms grow, they may get financing from debt sources, common equity (retained earnings or new common stock) sources, and even preferred stock sources.
In order to calculate an accurate cost of capital for the firm, we must calculate the proportion that debt and equity is of the business firm's capital structure and weight the cost of debt and the cost of equity by that percentage when calculating cost of capital. Then, we sum the weighted costs of capital to get the weighted average cost of capital.
Calculation of Cost of Debt Capital
The cost of debt for a business firm is usually cheaper than the cost of equity capital. Why is this? Because the interest expense on debt is a tax-deductible expense for the business firm. This is why many small business firms, unless they have investors, use debt financing.
The smallest of business firms may use short-term debt only to purchase their assets. For example, they may just use supplier credit (accounts payable). They could also just use short-term business loans, either from a bank or some alternative source of financing.
Here is the calculation for the cost of debt capital:
Cost of debt = Pre-tax cost of firm's bonds or short-term debt (1 - marginal tax rate)
Let's use an example. XYZ, Inc. uses mostly short-term debt in its operations through a line of credit at its bank. The line of credit has a variable interest rate based on market conditions but the average interest rate over the past year has been 9%. The company made about $20 million last year. Taking a look at the corporate tax tables, and realizing the corporate tax rates have been the same since 2008, you see that makes the company's marginal tax rate 35%.
Using the cost of debt formula, here is the calculation:
Cost of debt = 9% ( 1 - .35) = 5.85%
XYZ's cost of debt capital is 5.85%.
There are usually no underwriting or flotation costs associated with debt financing for a company.
Calculation of the Cost of Equity Capital
The cost of equity capital can be a little more complex in its calculation than the cost of debt capital. It is possible that the firm could use both common stock and preferred stock to raise money for its operations. Most firms do not use preferred stock. In this illustration, however, we will look at the cost of common stock only.
Most new equity capital that comes to businesses is raised by reinvesting retained earnings. Even retained earnings have a cost, called an opportunity cost. These earnings could have been used in some other way. For example, they could have been paid out as dividends to shareholders.
It is more difficult to estimate the cost of common stock (retained earnings) than the cost of debt. Most businesses use the Capital Asset Pricing Model (CAPM) to estimate the cost of equity. Here are the steps to estimate the cost of retained earnings:
- Estimate the economy's risk free rate.
The risk-free rate is usually the rate of return on U.S. Treasury bills.
- Estimate the stock market's current rate of return.
You can usually look at a broad stock market index, like the Wilshire 5000 and use the rate of return of that index as a proxy for the market rate of return.
- Estimate the risk of the stock of the company as compared to the market. This measure is called beta.
The beta (risk) of the market is specified as 1.0. If the company's risk is greater than the market, its beta is greater than 1.0 and vice versa. You can use historical stock price information to measure beta. You can adjust the historical beta for fundamental factors specific to the company. Often, it is a judgment call on the part of company management.
- Insert the variables into the CAPM equation.
Cost of Equity = Risk-free rate + Beta (Market Rate of Return - Risk-Free Rate)
Here is an example. If the risk-free rate on Treasury bonds is 2% and the current market rate of return is 5% and the beta of a company's stock is estimated to be 1.5, calculate the company's cost of equity (retained earnings) capital:
2% + 1.5(5% - 2%) = 6.5% = Cost of Equity
There are no underwriting or flotation costs associated with retained earnings.
Calculate the Weighted Average Cost of Capital
After you have calculated the cost of capital for all the sources of debt and equity that you use, then it is time to calculate the weighted average cost of capital for your company. You weight the percentage of the capital structure that each source of debt and equity capital is by the cost of the source of capital.
Here's what we have. The cost of debt capital was 5.85% and the cost of equity capital was 6.5%. If each made up 50% of the capital structure, here is the calculation for weighted average cost of capital:
WACC = .50(5.85) + .50(6.5) = 6.175%
If your company uses debt and equity financing in the way suggested above, the company's weighted average cost of capital will be 6.175%. If you add other sources of financing, you will need to add their component costs, such as that for new equity or preferred stock.
This is a general calculation of weighted average cost of capital using only the usual measures of debt and equity financing. The formula of weighted average cost of capital can be extended to include other sources of financing as stated above.