Weighted Average Cost of Capital (WACC) is an overall rate of return that a company must achieve on its assets (e.g. Plant & Equipment, Goodwill, Cash, Buildings, Accounts Receivable), capital (common & preferred shares) & debt borrowed (bonds & notes payable, long term loans) in order to maintain or increase its current value of the stock. WACC is expressed in percentage format. For example, if a corporation has a WACC of 15%, this means it must operate its business in such a way that overall rate of return from all assets & business operations exceeds 15%. This enables the company to grow, use its assets in profitable ventures & grow its market share in its industry. A decreasing WACC indicates the company is having operational or efficiency problems, problems with its capital structure (too much debt or equity) & financing or other corporate finance issues that must be investigated and corrected.

Large corporations such as Exxon Mobil or Johnson & Johnson need billions of dollars in Cash to finance their day to day business operations, make investments & acquisitions, pay income taxes, bonds payable and their workers' salaries & other expenses. How do they raise funds to start up or continue their business? Companies can raise capital by either i) issuing bonds payable and ii) issuing common & preferred shares to investors.

What happens when a company does both of these? It issues bonds payable to investors who are looking for annual or semi-annual bond coupon payments (source of debt) versus more common & preferred shares (source of equity). This mix of bonds (debt) and common shares (equity) is known as a corporation's Capital Structure. This mix of Capital Structure is important in how we calculate the weighted average cost of capital (see below).

Weighted Average Cost of Capital (WACC) Formula

The corporate finance formula for WACC is:

[By x D/C x (1-t)] + [Re x E/C]

By = Bond's yield to Maturity (I/Y in BAII Plus Calculator)

D = Market Value (Present Value) of Bonds

(1 - t) = 1 - tax rate = Interest tax shield deductibility of interest expense

Re = Shareholder's return requirement

C = Total value of all capital (Debt + Equity)

Example to Calculate WACC

Game Enterprises Inc. plans to issue 2,000 bonds payable notes that are currently selling on the market at 96.5 (bond discounted price). The coupon on this bond is expected to be 7% with interest paid annually. The maturity for these bonds to expire will be 5 years.

Furthermore, Game Enterprises Inc. has 4,000,000 million Common shares outstanding on the New York Stock Exchange (NYSE) with current market price of the stock at $25. The beta of the stock is 1.2 and the risk-free rate on US treasury bonds is 3.8%. The rate of return expected from the stock market is 12%. The corporate tax rate for this company is 35%. Using all this information, calculate the Weighted Average Cost of Capital.

i) Bond Calculations

N = 5 years I/Y = ? PV = 0.965 x 2,000 x $1,000 = $1,930,000 PMT = -$2,000,000 x 7% = $140,000 FV = $2,000,000 P/Y = 1 C/Y = 1 Solution I/Y = 7.87%

ii) Stock Calculations

First we must calculate the Shareholder required rate of return. Here's the formula:

Shareholder Return Requirement = Risk free rate + Beta (Stock Market Rate of Return - Risk free rate)

Re = Rf + B[Rm - Rf]

Re = 0.038 + 1.2 (0.12 - 0.038)

Re = 0.038 + 1.2 (0.082)

Re = 0.038 + 0.0984

Re = 0.1364

From this, we know the shareholder return requirement is 13.64%.

What is the total Capital Structure?

From the bond calculation above, we know the present value of the bonds is $1,930,000. What is the total Common shares capital?

Common shares capital = Current Stock Price x Common Shares Outstanding

Common shares Capital = $25 x 4,000,000

Common shares Capital = $100,000,000

Knowing this, let's calculate the total capital structure.

Total Capital Structure = $1,930,000 (bonds) + $100,000,000

Total capital structure = 101,930,000

Having derived all the required information, let's calculate Weighted Average Cost of Capital:

WACC = [By x D/C x (1-t)] + [Re x E/C]

WACC = [0.0787 x 1,930,000 / 101,930,000 x (1 - 0.35)] + [0.1364 x (100,000,000 / 101,930,000)]

WACC = [0.0787 x 0.019 x 0.65] + [0.134]

WACC = 0.00097 + 0.134

WACC = 0.13497

WACC = 13.5%

Interpret the WACC

A Weighted Average Cost of Capital of 13.5% means Game Enterprises Inc. must earn a minimum of 13.5% return on all its assets, capital (bonds & common shares) and its earnings per share number in order to maintain the current stock price at $25.

WACC Part 1 of 3 How to Calculate Weighted Average Cost of Capital Finance

View this funny and useful video on how to calculate Weighted Average Cost of Capital. Main highlights from this video are:

i) Where does Capital come from?

1. Borrowing from banks (debt) and/or
2. Owners/Investors put their own money in to the company (equity).

ii) What is Cost of Debt?

Bank interest rate (%) charged to your company e.g. 5%.

iii) What is Cost of Equity?

- Expected % return of Owners/Investors
- Can use Capital Asset Pricing Model (CAPM) to compute this.

iv) So now, What is the Cost of Capital?

- Capital comes from D (debt) & E (Equity).
- Depends on where you got the money to start/run your company.
- If you got the money from bank borrowing (5%), then your Cost of Capital is 5%