This is “Weighted Average Cost of Capital (WACC)”, section 12.5 from the book Finance for Managers (v. 0.1). For details on it (including licensing), click here.

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12.5 Weighted Average Cost of Capital (WACC)

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Compile the WACC equation.
  2. 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
rd = Interest rate on firm’s debt. Or the return on debt.
rd(1 − T) = After-tax cost of debt.
rps = Return on preferred stock
rs = Return on common stock
wd = Weight (%) of debt used by company
wps = Weight (%) of preferred stock used by company
ws = Weight (%) of common stock used by company
WACC = Weighted Average Cost of Capital
DPS = Dividend of Preferred Stock
PPS = Price of Preferred Stock
g = Growth rate of dividends of common stock
P0 = Price in time zero of a share of common stock
D0 = Dividend in time zero
D1 = Dividend in time 1

The weighted average cost of capital (WACC)The average of the returns required by equity holders and debt holders, weighted by the company’s relative usage of each. 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 = wdrd(1 − T) + wpsrps + wsrs

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 million

Total 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%

 

Then we plug in the weights and the component costs.

WACC = wdrd(1 − T) + wpsrps + wsrs 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

  1. Calculate WACC given the following:

    rs = 6 percent%, rd = 10%, rps = 4%, wd = 40%, ws = 50%, wps = 10%

  2. Calculate WACC given the following:

    rs = 5.5%, rd = 4.5%, rps = 7%, wd = 35%, ws = 45%, wps = 20%