Calculating Weighted Average Cost of Capital
Updated January 2, 2015 by Matt H. Evans
Weighted Average Cost of Capital (WACC) is the overall costs of capital. WACC is based on your current capital structure. Market values are used to assign weights to different components of capital. It should be noted that market weights are preferred over book value weights since market values more closely reflect how you raise your capital. Market weights are calculated by simply dividing the market value for each component by the sum of market values for all components. The following example illustrates how you calculate weighted average cost of capital.
Current Capital Structure consists three components: Long-term Debt (10 year A Bonds) with a book value of $ 400,000 and a cost of capital of 6.0%. Common Stock with a book value of $ 200,000 and a cost of capital of 18.0%. Retained Earnings with a book value of $ 50,000 and a cost of capital of 16.0%.
Determine Market Values for Capital Components. 10-Year grade A bonds are selling for $ 1,150 per bond and the common stock is selling for $ 40.00 per share. Assume we have 500 bonds outstanding and 15,000 shares of stock outstanding. Market Value for Debt is $ 575,000 ($ 1,150 x 500) and Market Value for Stock is $ 600,000 ($ 40.00 x 15,000).
Allocate the Equity Market Value between Common Stock and Retained Earnings based on book values. Common Stock = $ 480,000 ($ 200,000 / $ 250,000 x $ 600,000). Retained Earnings = $ 120,000 ($ 50,000 / $ 250,000 x $ 600,000).
Calculate the WACC using market weights:
The Debt (Bonds) has a market weight of .49 ($ 575,000 / $ 1,175,000) x .06 cost of capital = .029. Stock has a market weight of .41 ($ 480,000 / $ 1,175,000) x .18 cost of capital = .074. Finally, Retained Earnings has a market weight of .10 ($ 120,000 / $ 1,175,000) x .16 cost of capital = .016. This gives us a Weighted Average Cost of Capital of .119 or 11.9% (.029 + .074 + .016).
Written by: Matt H. Evans, CPA, CMA, CFM | Email: firstname.lastname@example.org | Phone: 1-877-807-8756