Weighted average cost of capital

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The weighted average cost of capital (WACC) is the average rate that a business pays to finance its assets. It is calculated by averaging the rate of all of the company’s sources of capital (both debt and equity), weighted by the proportion of each component.

More about WACC

Business owners can refer to their WACC in order to gauge the optimal balance of their company’s ratio of equity to debt.

The cost of equity in a business is generally higher than the interest rate it pays on its debt. This is because entrepreneurs usually seek a higher rate of return on their capital than what lenders charge for financing. Besides, interests paid on debt are tax deductible.

The consequence is that an increase in a company’s debt as a portion of total capital generally results in lower WACC. Obtaining lower financing rates also reduces WACC.

How to calculate WACC

The WACC is determined using the following formula.

Formula

WACC = k(SE) * [SE/(SE+D)] + [D/(SE+D)]*[k(D) * (1-tax rate)]

K(SE) = rate of return required by shareholders
SE = Shareholders’ equity
D = Total debt
K (D) = average interest rate on debt incurred

WACC sample calculation

Shareholders’ equity = $1000
Rate of return required by shareholders = 15%
Debt = $2000
Average interest rate on debt = 7%
Corporate tax rate = 25%

Formula

15% x (1000/(1000+2000)) + 7% x (2000/(1000+2000) x (1-0.25)

15% x 33.3% + 7% x 67.7% x 0.75

= 8.5%
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