What is the Weighted Average Cost of Capital?

We are a few weeks into the series of finance-related posts.  I figured I would explain this series a little before we go into today’s topic.  I am currently working on an Masters of Business Administration at Cardinal Stritch University, in Glendale, WI.  As I go through my homework, I often find that the textbook is not the best in the world and I have to pull concepts from a number of source.  With this content, I try to develop a reasonable narrative that pulls things together.  When I blog a topic like today’s topic, it’s my highly public way of doing that.  I hope it helps someone else out there.

Today, we’re going to talk a little about the Weighted Average Cost of Capital (WACC).  According to the third edition of Corporate Finance: Core Principles & Applications, “the WACC is the minimum return a company needs to satisfy all of its investors, including stockholders, bondholders, and preferred stockholders.”  According to investopedia, “all else being equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.”

So, essentially the WACC is the amount of profit that the firm has to earn, in order to satisfy all of its obligations and if the firm starts to look like a worse investment, they will need to earn more profit.  The formula for the WACC (according to investopedia) is:

[pmath size=10]WACC = (E/V)*R_e+(D/V)*R_d*(1-T_c)[/pmath]

Where:
[pmath size=10]R_E[/pmath] = cost of equity
[pmath size=10]R_d[/pmath] = cost of debt
[pmath size=10]E[/pmath] = the market value of the firm’s equity
[pmath size=10]D[/pmath] = the market value of the firm’s debt
[pmath size=10]V = E + D[/pmath]
[pmath size=10]E/V[/pmath] = percentage of financing that is equity
[pmath size=10]D/V[/pmath] = percent of financing that is debt
[pmath size=10]T_c[/pmath] = the corporate tax rate

So, let’s look at a small example problem.  Let’s say that a firm has a cost of debt of 5.2% and a cost of equity of 9.1%.  Let’s also say that the corporate tax rate is 39% and the firm’s debt-equity ratio is 0.6.  How would you figure out the firm’s WACC?

5.2% implies 5.2 parts debt for 10 parts equity and because the value is equal to the sum of debt plus the equity, the debt-value ratio is [pmath size=10]5.2/(5.2+10)=0.342105[/pmath].  The equity-value ratio would then be [pmath size=10]10/(5.2+10)=0.657895[/pmath].

[pmath size=10].657895 * 9.1% + .342105 * 5.2% * (1 – 39%) = 0.07072 = 7.072%[/pmath]

So, now that we know what the WACC is and how it’s calculated, is there an easy way to find the WACC for a publicly traded company?  Well, for better or worse, there is apparently an app for that. 🙂