How to calculate wacc
![](https://www.thetechedvocate.org/wp-content/uploads/2023/10/TermDefinitions_wacc_final-626b8af9bfc741d6a9792fe0568242cd-2-660x400.png)
How to Calculate WACC: A Comprehensive Guide
Introduction
Weighted Average Cost of Capital (WACC) is a critical financial metric that helps businesses and investors to evaluate the overall cost of funding a company. Essentially, WACC is used to measure the average rate a company expects to pay its investors for financing its assets. This guide will walk you through the step-by-step process of calculating WACC, making it simple for you to determine the financial health of an organization.
Step 1: Determine the weights of equity and debt
The first step in calculating WACC is determining the weights of equity (W_E) and debt (W_D). Begin by finding out the market value of the company’s equity and debt.
Market Value of Equity (E) = Number of outstanding shares × Price per share
Market Value of Debt (D) = Sum of all debt obligations
Next, calculate the total market value by adding the market value of both equity and debt.
Total Market Value (V) = Market Value of Equity (E) + Market Value of Debt (D)
Finally, compute the weights using the following formulas:
Weight of Equity (W_E) = Market Value of Equity (E) / Total Market Value (V)
Weight of Debt (W_D) = Market Value of Debt (D) / Total Market Value (V)
Step 2: Calculate individual costs
After determining weightings, you’ll need to calculate individual costs for both types of capital.
1.Cost of Equity (R_E):
Use the Capital Asset Pricing Model (CAPM) formula to find cost of equity:
R_E = R_f + β(R_m – R_f)
Where R_f is risk-free rate, β is stock beta, and R_m is market return.
2.Cost of Debt (R_D):
To find pre-tax cost of debt, divide interest expense paid on debt by total debt amount:
Pre-tax R_D = Interest Expense / Total Debt
For after-tax cost of debt, multiply pre-tax cost of debt by (1 – Corporate Tax Rate):
After-tax R_D = Pre-tax R_D × (1 – Corporate Tax Rate)
Step 3: Calculate WACC
Lastly, combine the weights and individual costs to determine WACC using this formula:
WACC = (W_E × R_E) + (W_D × R_D)
The resulting percentage is the weighted average cost of capital, which is the overall expected rate of return on a company’s financed investments.
Conclusion
Understanding the process of calculating WACC is essential for making informed investment decisions and measuring a company’s performance. By following these three steps — determining weights, calculating individual costs, and combining them — you’ll be able to evaluate the financial health of an organization and make enlightened decisions about whether or not to invest.