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How do you calculate the weighted average cost of capital?
In reality, few managers will ever make this calculation. “This is the job of finance professionals,” says Knight, “and to the average manager what goes into determining the cost of capital can often be opaque.” Here’s a brief overview (based on the example in Knight’s book, Financial Intelligence):
The first step is to calculate the cost of debt to the company. This is pretty straightforward. You take all of the money that the company has borrowed and look at the interest rates you’re paying. So if the company has a credit line with a rate of 7%, a long-term loan at 5%, and bonds that it uses to make acquisitions at 3%, you add that all up and calculate the average. Let’s say it’s 6%. Then because interest on debt is tax deductible you multiply it by the corporate tax rate (which is usually around 30% in the U.S.). The formula looks like this:
Cost of debt = average interest cost of debt x (1 – tax rate)
So you take your 6% and multiply it by (1.00-.30). In this case the cost of debt = 4.3%.
Now, set that number aside and move over to the equity calculation. This is a much more theoretical number and takes into account beta (risk) and prevailing interest rates.
The formula looks like this:
Cost of equity = risk-free interest rate + beta (market rate – risk-free rate)
Beta measures the volatility of the company’s stock compared to the market. The higher the beta, the riskier the stock is, according to investors. If a stock rises and falls at close to the same rate as the market, the beta will be close to 1. If it tends to rise and fall more than the market, it might have a beta closer to 1.5. And if it doesn’t fluctuate as much as the market, like a utility for example, it might be closer to 0.75.
The market rate is the expected return on the stock market right now. There is typically lots of debate about this number but generally it falls between 10-12%. The risk-free rate is the return you’d get on a risk-free investment, such as a treasury bill (somewhere between 1-3%). This figure can also be debated.
Let’s assume that that the company’s beta is 1, that it uses 2% for the risk-free rate and 11% for the market rate, then you’d get the following calculation:
2% + 1 (11% – 2%) = 11%
Note how important the beta can be. For example, if the company’s beta was 2 instead of 1, the cost if equity would be 20% instead of 11%. That’s quite a difference.
Now the next step is to take your two percentages – the cost of debt (4.3% in the example above) and the cost of equity (11%) – and weight them according to the percentage of debt and equity the company uses to finance its operations. Let’s assume the company uses 30% debt and 70% equity to run its business. So you’d do the following final calculation:
(0.3 x 4.3%) + (0.7 x 11%) = 8.99%
This is the company’s WACC.