# Calculate Weighted Average Cost of Capital

## The average cost of financing a company: What does it pay for debt and equity?

When companies raise money for expansion and other projects, they must pay for the use of these funds. If the company raises money from shareholders or receives a sum of cash from private investors, this is considered equity. Raising money by borrowing from a bank or issuing bonds qualifies as debt. Each of these methods has its own cost, which can be stated in terms of an interest rate.

### Explaining WACC

A company's weighted average cost of capital (WACC) is the average interest rate it must pay to finance its assets, growth and working capital.

The WACC 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.

The WACC is based on a company'sÂ capital structureÂ and is composed of bothÂ debt financing and equity financing.Â Cost of capitalÂ is a more general concept concerning the amount a firm pays to finance its operations without being specific about the composition of its capital structureÂ (debt and equity).

Some small business firms only useÂ debt financingÂ for their operations. Other small startups only useÂ equity financing, particularly if they are funded by equity investors such asÂ venture capitalists. As these small firms grow, it is likely that they will use aÂ combination of debt and equity financing.

Debt and equity make up theÂ capital structureÂ of the firm, along with other accounts on the right-hand side of the firm'sÂ balance sheetÂ such as preferred stock.

As companies grow, they may get financing from debt sources, common equity (retained earnings or newÂ common stock) sources, and evenÂ preferred stockÂ sources.

To calculate a simplified cost of capital for the firm, first review the firm's current capital structure and calculate its proportion of debt and equity.

Then weight the cost of debt and the cost of equity by the resulting percentages when calculatingÂ the costÂ of capital. Next, sum the weighted costs of capital and debt to get the WACC.

### Calculating the Cost of Debt

The cost of debt for a business firm is usually cheaper than the cost of equity capital. This is because the interest expense on debt is tax-deductible for the business firm. This is why many small business firmsÂ unless they have investors, useÂ debt financing.

The smallest of businesses may use short-term debt only to purchase their assets. For example, they may use supplier credit in the form of accounts payable. They could also just useÂ short-term business loans, either from a bank or someÂ alternative source of financing.

Larger businesses may useÂ intermediate or long-term business loansÂ or may even issueÂ bondsÂ to raise money for financing.

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Cost of debtÂ = Pre-tax cost of firm's bonds or short-term debt * (1 - marginal tax rate)

For example, XYZ, Inc. uses mostly short-term debt in its operations through aÂ line of creditÂ at its bank. The line of credit has aÂ variable interest rateÂ based on market conditions but the average interest rate over the past year has been 9.0 percent.

The company made a profit of approximately \$20 million last year. Taking a look at theÂ corporate tax tables, use aÂ marginal tax rateÂ of 35 percent.

Using the cost of debt formula, calculate as follows:

Cost of debt = 9.0 percent * ( 1 - .35) = 5.85 percent

XYZ's cost of debt capital is 5.85 percent.

There are usually no underwriting or flotation costs associated with debt financing for a company.

### Calculating the Cost of Equity Capital

The cost of equity capital can be a little more complex in its calculationÂ thanÂ the cost of debt capital. It is possible that the firm could use bothÂ common stockÂ and preferred stock to raise money for its operations. Most firms do not use preferred stock. This illustration considers the cost of common stock only.

Most new equity capital that comes to businesses is raised by reinvestingÂ 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 asÂ dividendsÂ 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:

1. Estimate the economy'sÂ risk-freeÂ rate.

The risk-free rate is usually the rate of return on U.S. Treasury bills.

2. Estimate theÂ stock market'sÂ current rate of return.

You can usually look at a broad stock market index, like theÂ Wilshire 5000Â and use the rate of return of that index as a proxy for the market rate of return.

3. 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.

4. Insert the variables into the CAPM equation.

Cost of Equity = Risk-free rate + Beta (Market Rate of Return - Risk-Free Rate)

For example: If the risk-free rate on Treasury bonds is 2 percent and the current marketÂ rate of returnÂ is 5 percent and the beta of a company's stock is estimated to be 1.5, calculate the company's cost of equity (retained earnings) capital:

Cost of Equity = 2 percent + 1.5(5 percent - 2 percent) = 6.5 percentÂ

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 WACC for your company. You weight the capital structure using the percentage for each source of debt and equity capital.

The cost of debt capital was 5.85 percent and the cost of equity capital was 6.5 percent. If each made up 50 percent of a company's capital structure, the calculation forÂ the WACC follows as:

WACC = .50(5.85) + .50(6.5) = 6.175 percent

If your company uses debt andÂ equity financingÂ in the way suggested above, the company's WACC will be 6.175 percent. If you add other sources of financing, you will need to add their component costs, such as that for new equity orÂ preferred stock.

This is a general calculation ofÂ the WACC using only the usual measures of debt and equity financing. The formula of WACC can be extended to include other sources of financing as stated above.

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