Think & Done

We explain WACC with example calculation using WACC formula. weighted average cost of capital = cost of equity + cost of preferred stock + after tax cost of debt. Here we will have an in depth view of the way WACC or weighted average cost of capital is calculated using its components of cost of equity, cost of preferred stock and after tax cost of debt.

What is WACC

The question you may ask is what in the world is WACC? The short answer is that WACC is weighted average cost of capital that corporations use in capital budgeting project evaluation. The WACC usually consists of sum of three weighted costs:

1. Cost of Common Equity
2. Cost of Preferred Stock
3. Cost of Debt

Cost of Common Equity

Common Stock issuance is one way to raise capital for companies, and most investors tend to invest when they find a desirable rate of return on their investment. Since the main purpose of running corporations is to maximize the return for it's shareholders thus providing a higher rate of return to these in turn becomes the prime objective for corporate managers. Cost of Common Equity is infact the rate of return for common stocks, which is part of the dividend growth model as illustrated else where on this site. The equation for the valuation of common stock is as follows:

P = D/(kcs-g)

Here P is the price of the common stock,
D is the dividend
kcs is the rate or return
and g is the growth rate

Rearranging the equation we can find the cost of common stock as follows:

kcs = g + D/P

The term weighted cost of capital refers to the fact that we assign weights to each of the costs of common equity, cost of preferred stock and cost of debt. Thus if the volume of common stock makes up 50% of the total funding. Then cost of common equity will be 0.5 kcs

Cost of Preferred Stock

If the corporation were to go in to liquidation, the preferred stock owners will the first right to its proceeds, the common stock holders have voting rights yet the common stock holder do not have the first right to corporate assets in case a company were to be desolved. The cost of preferred stock is also derived from the formula to find the value of preferred stock which is:

P=D/kps

where P is the price of preferred stock
D is the dividend
kps is the rate or return

Rate of return on preferred stock is also the cost of preferred stock. Rearranging this we can find the cost of preferred stock as

kps=D/P

We do assign weights to this, thus if Preferred stock amounted to 20% of the total funding then the weighted cost of preferred stock will be 0.2kps

Cost of Debt

Cost of debt is in turn cost of issuing bonds for long terms securities, the formula that finds the value of long term debt is the sum of discounted interest payments and the discounted maturity value. The market rate of return used in the formula is also the cost of debt. There isn't any easy way to solve for cost of debt thus we rely on computer programs to find cost of debt or we approximate it with linear interpolation. Here too we assign weights to this cost of debt thus if debt made up 30% of the total funds then cost of debt will be 0.3kd. But since this is pretax cost of debt, we usually rely on after tax cost of debt which is to be had with kd(1-Tax Rate)

Putting it All together

As an illustration, say IBM has a target capital structure calling for 30% debt, 20% preferred stock and 50% common equity. It's pre tax cost of debt kd is 10%, its after tax cost of debt kd(1-Tax Rate) is 10%(0.66) = 6.6%, its cost of preferred stock kps is 10.5% and its cost of common equity kcs is 15%. We can find IBM's weighted average cost of capital as follows:
WACC = wdkd(1-Tax Rate) + wpskps + wcskcs
WACC = 0.3(6.6%) + 0.2(10.5%) + 0.5(15%)
WACC = 0.0198 + 0.021 + 0.075
WACC = 0.1158
WACC = 11.58

Related DCF analysis methods

Following is a list of related readings that cover other 5 commonly used DCF analysis methods

1. Internal Rate of Return
2. Modified Internal Rate of Return
3. Net Future Value
4. Net Present Value
5. Profitability index
6. Payback period