Weighted average cost of capital
(WACC). 1. The average cost of capital of a firm, taking into account all sources of capital, weighted by their current market values.
For a firm with both equity and debt capital, the WACC would be calculated as:
WACC = Ke x E/[D+E] + Kd(1-t) x D/[D+E]
Where: Ke = cost of equity. Kd(1-t) = after tax cost of debt. E = market value of equity. D = market value of debt.
For example where: Ke = cost of equity = 10% Kd(1-t) = after tax cost of debt = 3.6% E = market value of equity = $100m D = market value of debt = $100m
WACC = Ke x E/[D+E] + Kd(1-t) x D/[D+E] = 10% x 100/[100+100=200] + 3.6% x 100/[100+100=200] = 5% + 1.8% = 6.8%
This weighted average is exactly mid-way between the cost of equity and the after-tax cost of debt, because the proportions of equity and debt are exactly equal in this example.
2. In order to create or add shareholder value, the managers of this firm would need to earn an after-tax rate of return on their investment projects of more than the WACC of 6.8%.
See also
