Weighted Average Cost of Capital (WACC)
This section presents the WACC in more detail. Why is the WACC so important?
Learning Objectives
- Compile the WACC equation.
- Solve for WACC.
Now that we have calculated all of our component costs, calculating the WACC is simple. We plug into our formula and solve.
Table 12.1 Components of WACC
Variable | = | Definition |
---|---|---|
r_{d} | = | Interest rate on firm’s debt. Or the return on debt. |
r_{d}(1 − T) | = | After-tax cost of debt. |
r_{ps} | = | Return on preferred stock |
r_{s} | = | Return on common stock |
w_{d} | = | Weight (%) of debt used by company |
w_{ps} | = | Weight (%) of preferred stock used by company |
w_{s} | = | Weight (%) of common stock used by company |
WACC | = | Weighted Average Cost of Capital |
D_{PS} | = | Dividend of Preferred Stock |
P_{PS} | = | Price of Preferred Stock |
g | = | Growth rate of dividends of common stock |
P_{0} | = | Price in time zero of a share of common stock |
D_{0} | = | Dividend in time zero |
D_{1} | = | Dividend in time 1 |
The
weighted average cost of capital (WACC) takes the return from each
component and then appropriately ‘weights' it based on the percentage
used for financing. The weights must sum to one and it is easiest to use
decimals. In words the equation is:
Equation 12.7 WACC components (words)
WACC
= (% of debt)(After-tax cost of debt) + (% of preferred stock)(cost of
preferred stock) + (% of common stock)(cost of common stock)
Or
WACC =
(% of debt)(Before-tax cost of debt)(1−T) + (% of preferred stock)(cost
of preferred stock) + (% of common stock)(cost of common stock)
Using symbols, the equation is:
Equation 12.8 WACC components (symbols)
WACC = w_{d}r_{d}(1 − T) + w_{ps}r_{ps} + w_{s}r_{s}
Worked Example: Falcons Footwear - CAPM to calculate rs
Falcons
Footwear has 12 million shares of common stock selling for $60/share.
They have 2 million shares of preferred stock selling for $85/share and
$100 million in bonds trading at par. They are in the 40% tax bracket.
First we calculate the total market value:
Total market value of common stock = 12 million*$60 each = $720 millionTotal market value of preferred stock = 2 million shares*$85 each = $170 million
Total market value of bonds = $100 million trading at par = $100 million
Total market value = 720 + 170 + 100 = $990 million
From this we get the weights:
Percentage of common stock = $720 / $990 = 72.7%
Percentage of preferred stock = $170 / $990 = 17.2%
Percentage of debt = $100 / $990 = 10.1%
Total equals = 100%
Percentage of preferred stock = $170 / $990 = 17.2%
Percentage of debt = $100 / $990 = 10.1%
Total equals = 100%
Then we plug in the weights and the component costs.
WACC = (0.101)(0.07)(1−0.4) + (0.172)(0.0882) + (0.727)(0.092)
WACC = 0.0042 + 0.0152 + 0.0668 = 0.0862 or 8.62%
For Falcons Footwear the WACC is 8.62%.
Key Takeaway
- The Weighted Average Cost of Capital is the component returns multiplied by their respective weights.
Exercises
- Calculate WACC given the following:
r_{s} = 6 percent%, r_{d} = 10%, r_{ps} = 4%, w_{d} = 40%, w_{s} = 50%, w_{ps} = 10%
- Calculate WACC given the following:
r_{s} = 5.5%, r_{d} = 4.5%, r_{ps} = 7%, w_{d} = 35%, w_{s} = 45%, w_{ps} = 20%
This text was adapted by Saylor Academy under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work's original creator or licensor.
Last modified: Thursday, December 23, 2021, 12:24 PM