Understanding the weighted average cost of capital

The weighted average cost of capital (WACC) is a measure of proportional capital cost to businesses and corporations seeking an assessment of multiple forms of capital infusion. For example, if company A issues corporate bonds, shares and takes on loans it incurs multiple sources of capital. Since the amount and percentage of capital varies with each type of capital it's cost must be determined using a specific calculation, namely the weighted average cost of capital.

Key attributes of the weighted average cost of capital

The weighted average cost of capital serves as a financial tool for financial managers, business analysts, accountants, shareholders and others. The WACC equation is a metric that facilitates financial positioning within the time period represented by the numbers used in the equation. In other words, sudden changes in interest rates, price to earnings ratios, and market conditions may not be reflected in WACC calculations. Some of the features of the WACC calculation are as follows:

• Assists in determining capital leveraging cost
• Aids financial analysts in streamlining corporate budgets
• Shareholders, strategic planners & others determine financial positioning
• Provides a meaningful method to compare cost competitiveness 
• Defines percentage cost for a given set of capital components
• Is also used in determining Discounted Cash Flow (DCF)

How to calculate the weighted average cost of capital

To calculate WACC one needs to know the percentage proportion of each form of capital, the dollar amount and each components cost. For example, Company A may have a 4th quarter capital distribution of 25% Corporate bonds, 40% common stock, 10% preferred stock and 25% business loans. Each of these forms of capital have different costs. Moreover, the corporate bonds may cost 6% in interest, the common stock may cost 12% return including dividends, 14% for the preferred stock and 5% for the business loan(s). Using these percentage costs, they can be entered into the following WACC equation.² 

Step 1: Cost of Equity: If issued shares are a component cost of WACC a cost of equity calculation can be used to determine its cost. Calculating cost of equity can be achieved in a number of ways, two of which include the 1) Capital asset pricing model, 2) dividing dividends plus expected return by market price¹ and 3) Expected shareholder return. Additionally, if the share are new issues, the cost of equity can include investment bank fees and costs associated with the issue.

EX: Shareholders of company A expect an $1.10 return on an $11.00 stock making the 'cost of equity' $1.10/$11.00=10%. If company A also issues dividends, the dividend cost is added to the expected shareholder return i.e. a .20 cent annual dividend + $1.10=$1.30/$11.00=11.8%

Step 2: WACC=%Weight of component 1 (1-T) + % weight of component 2 (component 2)+ % weight of component 3(component 3)+% weight of component 4 (1-T) where T= 10% tax cost reduction or 90% of bond and loan debt.

Thus, WACC=.25(6%)(.9)+.40(12%)+.10(14%)+.25(5%)(.9)
=.25(5.4%)+.4(12%)+.10(14%)+.25(4.5%)
=1.36%+4.8%+1.4%+1.125%
WACC=8.685%

Advantages and disadvantages of WACC 

Of particular relevance to the weighted average cost of capital is the cost of equity value. Since market price of equity is not generally static, the true cost of capital varies and since investors expectations vary the cost of capital may not be an exact figure. However, the WACC calculation is useful in determining a strong estimate if not an exact cost of capital leveraging. Ideally, the lower the WACC percent is, the better for the company. The WACC calculation can also serve as a metric to compare against a cost benchmark.

However, it is also important to note how the numbers in the WACC equation can be somewhat misleading. For example, if a manager at Company A decides WACC is too high and consequently pays off a loan using retained earnings, the loan portion of the WACC calculation will decline assuming no other loans are taken. This could actually increase the cost of capital as the remaining capital may be in a higher cost equity leveraging. Thus, WACC should not be considered an operating cost but rather a measure of capital distribution and the cost associated with that distribution of that funding.

Additionally, if corporate performance, market and economic conditions are favorable the company's valuation may rise causing WACC to change for the better if shareholders expectations do not adjust. If loan debt is variable rather than fixed, changes in the interest rate of such debt can also cause fluctuations in WACC. Henceforth, being aware of the terms, conditions, context and environment of capital costs is essential in interpreting the result of the WACC calculation.

Summary

In Summary, the weighted average cost of capital (WACC) is a metric used in finance to quantify percentage distribution of cost for more than one non-equal sources of capital. The measurement helps businesses ensure adequate cash-flow, assists with debt management decisions, and provides a quantitative value with which to evaluate financial decisions. In essence, the average is 'weighted' based on the proportional amount of each type of capital. WACC can be calculated using a tax deduction for after tax cost of capital and may include a cost of equity component which itself can be calculated in more than one way. 

For these reasons and changes in cost conditions, a WACC calculation may have a short expiration in terms of validly and accurately representing capital cost(s). Nevertheless, the WACC calculation is useful in determining how a company is financed, and what that capital costs. The WACC calculation serves as an indicator, benchmark, and guide to financial practitioners seeking to gain a more accurate understanding of corporate capital structure.

Sources:

1. http://www.investopedia.com/terms/c/costofequity.asp
2. Eugene F. Brigham and Michael C. Ehrhardt. "Financial Management: Theory and Practice 10th Ed." Southwestern. 2002 p.420-422.
Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p277-281.