How to Determine Your WACC
WACC is an acronym for “Weighted Average Cost of Capital” and it describes what, on average, a corporation must pay out to all its security holders. This is the average cost of the financing on a corporation’s assets. WACC is also the minimum amount of return a corporation must earn in order to satisfy all the creditors within its capital structure. WACC is of great importance when determining whether or not an investment has the potential for positive returns.
Determining a corporation’s WACC becomes more complex as the number of capital components involved in the financing increases. By taking a weighted average of a corporation’s total interest, we are able to determine how much return is required on an on-going basis to satisfy all investors providing funds.
In order to calculate a corporation’s weighted average cost of capital, the following elements are required:
- Cost of Equity (Re)
- Cost of Debt (Rd)
- Market Value of Equity (E)
- Market Value of Debt (D)
- Total Debt plus Equity (V)
- Percentage of Financing Represented by Equity (E divided by V)
- Percentage of Financing Represented by Debt (D divided by V)
- Corporate Tax Rate (Tx)
Using the above values, WACC can be calculated as follows:
WACC = [(E / V) X Re] + [(D/V) X Rd X (1 - Tx)]
By calculating a corporation’s WACC, management can use this weighted average to see how much interest is being paid for every dollar of financing it has on the books.
For a more in-depth method of calculating WACC, have a look at the following article that discusses the true definition of WACC as well as some misconceptions and common errors made when calculating WACC. This paper explains the true meaning of weighted average cost of capital and therein 7 errors due to "not remembering the definition of WACC". The seven errors mentioned in the article include the following:
- using the wrong tax rate
- using the book value of debt and equity instead of the correct valuation
- assuming a capital structure that is neither the current nor forecasted structure
- failure to satisfy the "time consistency formulae" (see the paper)
- assuming the incorrect return on assets
- using the wrong formula to calculate WACC (two methods are given in the paper)
The paper also discusses the challenges with calculating the value of a tax shield (VTS) and proposes a method to address said challenges.