If you think about investing or bring investors to your business, you may need to learn how to calculate the weighted average cost of capital (WACC)
Why? Well, as we often say here at Freenvoice:
When you don’t know your numbers, you can’t tell how much money you can lose (or already losing)!
So let’s take a look at why you should know your WACC and how to calculate it.
What is WACC?
In essence, WACC is the minimal rate of return at which the company will pay the profits to the investors. You need to know this number if you want to get a better sense of how much your business is really worth since it includes data both on your equity and debt costs.
Image Source: Business Valuation Modeling Course.
What Does WACC Tell Us?
WACC helps you answer three important financial questions:
- How much interest does the company have from each dollar it finances?
- What kind of return the shareholders and debt holders can expect?
- How risky is it to invest in a particular company?
As you see, it’s kinda a big-deal-of-a-metric. Now, let’s take a look at the formula that will help you to calculate WACC. Don’t worry! We explained the most challenging bits in detail.
How To Calculate WACC
Let’s start by breaking this formula by its key components. The Weighted Average Cost of Capital formula is this:
WACC = (E/V) x Re + (D/V) x Rd x (1-Tc)
- E represents the market value of the company’s total equity.
- V is what we can break up into E + D (equity + debt). V stands for the total market value of the financing
- E/V comes for the equity percentage in company financing.
- Re is for the total cost of the company’s equity.
- D stands for the market value of the company’s total debt.
- D/V comes for the debt percentage in company financing.
- Rd is for the total cost of the company’s debt.
- Tc comes for the effective tax rate.
Ok, so you are probably confused at this point. But bear with me! Once you calculate the Equity and Debt parts of the formula, things get easier. Promise! So let’s get done with the complicated part.
Cost of Equity (Re) Calculation
First, here’s your formula:
CMV/DPS + GRD = Cost of Equity
- DPS stands for the dividends per share the company needs to pay the next year.
- CMV stands for the current market value of the company’s stock.
- GRD stands for the dividends’ growth rate.
Quite simple, right? Now let’s illustrate this further with an example.
So one company is regularly paying out dividends. Its stock price is $25, and it expects to pay the dividends of $4,00, with the following payment history:
|Year||Dividend per share|
Let’s calculate the average growth rate of dividends.
((3,50/3,05 – 1 )+ (3,75/3,50 -1))/2 = (0,14 + 0,07)/2 = 0,105%
So your average growth rate equals 0,105%. Now we have all we need to proceed with the cost of equity calculation.
DPS for the next year is $4,00, CMV is $25, and GRD is 0,105%.
So, your cost of equity equals:
$25/$4 + 0,105% = 6,355%
Cost of Debt (Rd) Calculation
Please, take a look at the formulas below.
Effective Interest Rate X (1 – Tax Rate) = Cost of Debt
The key number here is the effective interest rate. Here’s how to calculate it:
100 X (Annual Interest / Total Debt) = Effective Interest Rate
This one’s best illustrated with an example.
Let’s say some company took a loan of $100,000 from a bank for one year, with an interest rate of 7%. The annual interest expense based on the loan amount will be $7,000. And the tax is 20%. Now let’s do the maths:
(100 X (7%/100,000)) x (1-20%) = $5600
So the company’s cost of the debt is $5,600.
WACC Calculation Example
Now aside from the cost of debt and the cost of equity, you’ll also need to know the following parameters for the final WACC calculation:
- The total market value of equity and debt
- An effective tax rate
Here’s your formula for the latter:
Income Tax Expense/Earnings Before Taxes (EBT) = Effective Tax Rate
Nothing complicated, right? Now, to find out the total market value of equity and debt, you just need to combine those numbers.
Now, let’s calculate your WACC number. As you remember, the formula is:
WACC = (E/V) x Re + (D/V) x Rd x (1-Tc)
Let’s assume the company has the following numbers:
Total equity value (E) = $5.200.000
Total equity and debt value (V) = $7.300.000
The total cost of equity (Re) = 6%
Total debt value (D) = $1,300,000
Total debt cost (Rd) = 4%
Effective tax rate (Tc) = 20%
WACC = ($5,200,000/$7,300,000) x 0.06 + ((($1,300,000/$7,300,000) x 0.04) x (1-0,2))) = 0,0427 + 0,005 = 0,432 or 4,32%
The company you examine has a WACC of 4,32%. That means for each dollar investors put in this company, you need to return an extra $0,43.
We hope that after reviewing all the examples from this article, you understood what WACC is. The calculation itself gets pretty straightforward if you know the Re and Rd numbers for your company (or the one you’d want to invest in!).
Photo by Eduardo Rossas