Calculating a Company’s WACC
This calculator can be used to determine a company’s weighted average cost of capital, also referred to as WACC. The calculator needs a total of thirteen inputs, including:
- The number of common shares of stock outstanding
- The current market price of the company’s common stock
- The common stock’s beta, which is a measure of volatility relative to the entire stock market
- The risk-free rate of interest, U.S. Government Treasury Bills (T-Bills) are frequently used to model a risk-free rate
- The company’s risk premium, which is the expected rate of return for the stock in excess of the risk-free rate
- The amount of debt carried by the company as indicated on the balance sheet
- The interest expense of the company as found on the income statement
- The average time to maturity for the company’s debt
- The pretax cost of the company’s debt
- The company’s incremental income tax rate
- The shares of preferred stock outstanding, if any
- The current market price of the company’s preferred stock
- The annual dividend per share provided by the preferred stock
The calculator then provides the user with twelve outputs (three sets of four):
- The company’s total capitalization, including equity, debt, and preferred (in thousands of units)
- The relative weight of each component of the company’s capitalization, which is found by taking each component of the company’s total capitalization and dividing it by the total
- The cost of each capitalization component (equity, debt, and preferred) and the company’s weighted average cost of capital (WACC), which is found by multiplying the cost of each component by its weight
Why Calculate a Weighted Average Cost of Capital?
A company’s weighted average cost of capital, or WACC, approximates the rate a company pays to finance its assets from all sources. This includes shares of common and preferred stock as well as all forms of debt, such as bonds. This measure is used by analysts when benchmarking performance of a company with its industry peers. Generally, lower WACCs are seen as desirable since it indicates the company’s cost to borrow capital is lower.
WACC values also used by company management when assessing new investment opportunities. For example, when a company’s finance organization is modeling the returns of a potential investment, it will use its WACC to discount cash flows. Since the WACC represents how much it costs the company to raise funds, any new investment should provide a return that is equal to, or greater than, its WACC. If that investment provides a return that is lower than the company’s WACC, it destroys value. Likewise, if that investment provides a return in excess of the company’s WACC it is generating excess returns, thereby creating value.
This is why cash flows are discounted by the company’s WACC. If the net present value (NPV) of cash flows, discounted using a company’s WACC, is greater than zero then it is creating value. If the NPV of cash flows model results in a negative value when discounted by the company’s WACC it is destroying value.
Variables Required by this Calculator
While most of the variables used by this calculator are straightforward, such as shares outstanding and market prices, there are several that required some explanation. Beta is a measure of the stock’s price volatility relative to the broader market. When calculating the cost of equity, the risk premium is multiplied by the stock’s beta then added to the risk-free rate. Typically, the rate of return on long-term (ten-year) US government treasury bonds can be used as a proxy for the risk-free rate. In terms of risk premiums, historical stock market data indicate a risk premium for equities that ranges from three to five percent. The average maturity of debt is also a variable that is not readily available. This value is calculated by taking the weighted average of all debt issued by the company. Admittedly, this value can take time to calculate. Sources such as Yahoo Finance are a useful resource when trying to quickly find some of these variables.