Weighted Average Cost of Capital (WACC) Examples

WACC, or Weighted Average Cost of Capital, represents a company's average cost of financing its assets. It's the rate a company is expected to pay on average to all its security holders to finance its assets. Knowing a company's WACC is crucial for investment decisions, capital budgeting, and valuation. Let's explore some practical examples of WACC calculations. Example 1: Simple WACC Calculation Imagine a company, "TechSolutions," has the following capital structure: * Equity: $5 million, with a cost of equity of 12%. * Debt: $3 million, with a cost of debt of 6%. * Tax Rate: 25%. First, we calculate the weights of equity and debt: * Weight of Equity (We) = Equity / (Equity + Debt) = $5 million / ($5 million + $3 million) = 0.625 or 62.5% * Weight of Debt (Wd) = Debt / (Equity + Debt) = $3 million / ($5 million + $3 million) = 0.375 or 37.5% Next, we calculate the after-tax cost of debt: * After-tax cost of debt = Cost of Debt * (1 - Tax Rate) = 6% * (1 - 0.25) = 4.5% Finally, we calculate the WACC: * WACC = (We * Cost of Equity) + (Wd * After-tax cost of debt) * WACC = (0.625 * 12%) + (0.375 * 4.5%) = 7.5% + 1.6875% = 9.1875% Therefore, TechSolutions' WACC is approximately 9.19%. This means that for every dollar invested in the company, it needs to generate a return of at least 9.19% to satisfy its investors. Example 2: Incorporating Preferred Stock Consider "GlobalIndustries" with the following: * Equity: $10 million, cost of equity = 15% * Debt: $5 million, cost of debt = 8% * Preferred Stock: $2 million, cost of preferred stock = 7% * Tax Rate: 30% First, calculate the weights: * Weight of Equity (We) = $10m / ($10m + $5m + $2m) = 0.588 * Weight of Debt (Wd) = $5m / ($10m + $5m + $2m) = 0.294 * Weight of Preferred Stock (Wp) = $2m / ($10m + $5m + $2m) = 0.118 After-tax cost of debt: * After-tax cost of debt = 8% * (1-0.30) = 5.6% WACC calculation: * WACC = (We * Cost of Equity) + (Wd * After-tax cost of debt) + (Wp * Cost of Preferred Stock) * WACC = (0.588 * 15%) + (0.294 * 5.6%) + (0.118 * 7%) = 8.82% + 1.65% + 0.83% = 11.3% GlobalIndustries' WACC is 11.3%. Including preferred stock demonstrates how to incorporate different capital sources into the WACC calculation. Example 3: Using Market Values Suppose "RetailGiant" is publicly traded. * Equity: 1 million shares outstanding, trading at $50/share, cost of equity = 10%. * Debt: $20 million outstanding, cost of debt = 7%. * Tax Rate: 35% Equity Market Value = 1,000,000 shares * $50/share = $50,000,000 Total Capital = $50,000,000 (Equity) + $20,000,000 (Debt) = $70,000,000 Weights: * We = $50m / $70m = 0.714 * Wd = $20m / $70m = 0.286 After-tax cost of debt = 7% * (1-0.35) = 4.55% WACC = (0.714 * 10%) + (0.286 * 4.55%) = 7.14% + 1.30% = 8.44% RetailGiant's WACC, calculated using market values, is 8.44%. Using market values, especially for equity, offers a more current reflection of investor expectations and risk perceptions.