CFA CFA Level 1 How do you calculate weighted average cost of capital (WACC)?

# How do you calculate weighted average cost of capital (WACC)?

Topic Resolution: Resolved
• Author
Posts
• gontata
Participant
• CFA Level 1
6

I need some help understanding the constituent parts of the WACC formula, and what WACC tells you. Is it better to have a high or low WACC, and is it an indicator or something the company can adjust?

• Zee Tan
Keymaster
• CFA Charterholder
2

What is WACC?

WACC is the weighted average cost of capital for a company – in simple terms, the answer to this question: How much do I have to pay, in % terms, for company funding? For equity, this is e.g. dividend payments, and for debt, it’s interest payments.

It’s the company’s cost of capital for each category, averaged and weighted proportionately.

WACC includes all sources of capital, including common stock, preferred stock, issued bonds or any other long-term debt.

WACC Formula:

where:

• Requity = Cost of equity (required rate of return)
• Rdebt = Cost of debt
• Taxc = Corporate tax rate

High or low WACC does not necessarily mean better or worse, as you need to take the different circumstances of each company into account.

• A high WACC generally means there’s a higher risk to fund this company (hence investors and debtors demand a higher cost of capital).
• A low WACC means the company can obtain funds cheaply and their operations are relatively low risk.

A company can configure its financing structure, which could change the proportion of debt to equity, but WACC is a result of the return investors demand, so it’s not something that you can directly adjust with financial restructuring, but its (in theory at least) a reflection of the company’s risk profile.

• Zee Tan
Keymaster
• CFA Charterholder
1

One way to look at it is from the investor’s perspective. If a given company’s WACC is 17%, this means on average you should require a 17% return on your investment to invest in this company. There will be different required rates of return depending on the type of funding (i.e. equity or debt), but on a weighted-average basis, the WACC is 17%.

So if the company is returning 25%, this means that the company is doing well from investors’ perspectives, and yielding 8% over the WACC (‘average required rate of return’).

The debt portion of WACC is multiplied by the tax rate because cost of debt Rdebt refers to the before-tax cost of debt, since interest payments are tax-deductible, i.e. on the P&L, interest payments are made before corporate tax is levied on company profit. Cost of equity Requity is after-tax (you pay your shareholder dividends after corporate tax).

So to calculate WACC, you have to make both equity and debt components after-tax, so you multiple the cost of debt component with 1 – corporate tax % to get the effective after-tax cost of debt.

• gontata
Participant
• CFA Level 1
0

Thanks!

I’ve seen an explanation in my notes that compares WACC with company returns, such as this:

• Company returns: 25%
• WACC: 17%
• Investment yield: 8%

I can deduce mathematically that

Investment Yield = company returns – WACC

from the example, but I’m having issues understanding that conceptually.

The other thing that I don’t understand is why does the debt part of the WACC calculation involve corporate tax, but the equity part doesn’t.

• blakein65
Participant
• CFA Level 3
0

WACC = (E / V) * Re + (D / V) * Rd * (1 – Tc)

E: Market value of the company’s equity (common and preferred stock)
V: Total market value of the company (E + D)
Re: Cost of equity (expected return rate for shareholders)
D: Market value of the company’s debt (bonds, loans)
Rd: Cost of debt (interest rate on debt)
Tc: Corporate tax rate

• Low WACC is generally preferable: It signifies a company can access capital at a lower cost, leading to potentially higher profitability and attractiveness to investors.
• High WACC can be detrimental: It implies a higher cost of capital, which can hinder profitability and make it harder to compete in the market.