The weighted average cost of capital, WACC, is a calculation used to determine what the firm is paying in interest on their capital, what is their cost of financing.  Their capital, financing, includes all of their equity, i.e. stock, and debt.  Each piece of capital is weighted against its discount proportionally.  For instance, the interest rate on their debt would be multiplied against the amount of debt that they have (as well as their tax rate) to find the weighted average of the debt side of their capital.

The equation for calculating WACC is as follows:

WACC = (E/V)Re + (D/V)Rd(1-Tc)

Where:

E = market value of the firm’s equity

V = the total capital of the firm, equity + debt (E+D)

Re = the cost of equity

D = market value of the firm’s debt

Rd = the cost of debt

Tc = the corporate tax rate

Finding most of the values for these variables is fairly simple, but a few of them can be a little tricky.  E, the market value of the firm’s equity, will be found on the company’s financial statements, add up all the equity accounts.  (Remember these can usually be found on the company’s website under at term similar to “investor relations” or at google.com/finance or finance.yahoo.com.) D, the market value of the firm’s debt, will also be found on the company’s financial statements, add up their liabilities.  Add E and D together and you will get V, which is the value of the firm’s capital, however, not yet appropriately weighted).  E/V is the percentage of the firm’s financing that is done through equity, and E/D is the percentage of the firm’s financing that is done through debt.  Re, the cost of equity, is more difficult to calculate and requires another model.  The capital asset pricing model ( CAPM ) is the most recognized and popular model for calculating the cost of equity and uses beta, risk free rates, and expected market return to calculate.  Another method is the dividend calculation model which uses current dividends being paid by the company’s stock, the current market value of the stock, and the growth rate of those dividend payments.  Rd, the cost of the firm’s debt, is easier to find as it is the current rate they are paying on their debt and should be disclosed.  A company is able to benefit on their taxes from the interest that they pay so it is important to also multiply their debt by 1 minus their tax rate to get a more appropriate valuation, (1-Tc).

Now that you know how to calculate the WACC, it’s valuable to know how to apply it and how to value what you are applying.  Because assumptions have to be made when calculating Re, the cost of equity, (assumptions either about how to calculate the beta or what the dividend growth rate will be) the number one person gets for their calculation of WACC can vary from another’s.  However, WACC still gives you a good idea of at what value cash flows should be discounted at to get their present value.  Another way to think of the WACC is the required return that a company has, as this is what they need generate in order to cover their interest on their financing activites.  The WACC is often used in Discounted Cash Flow anaylsis (DCF) to find the appropriate value to discount the cash flows at for Net Present Value (NPV).