The weighted average cost of capital (WACC) is a critical piece of valuing projects and understanding capital structure. Let’s walk through how to calculate the cost of capital including an example in Excel.
What is Cost of Capital?
A company’s cost of capital is the rate at which it can raise cash to make investments in the business. The most common application, WACC, stands for the weighted average cost of capital. WACC blends a company’s cost of equity and cost of debt to create a “hurdle rate.” A hurdle rate is the minimum rate an investment should return to add value.
This hurdle rate goes hand in hand with the Internal Rate of Return (IRR) calculation. IRR provides an annual rate of return assuming that the Net Present Value (NPV) of a project is zero. If the IRR exceeds the company’s cost of capital, then it will likely provide a favorable return. If you have multiple projects, the project with the highest IRR is typically the best investment.
If the formula looks overwhelming at first, don’t worry. It’s just a slight twist on the weighted average calculation. Here is what each piece of the formula means:
E=Market value of the company’s equity
D=Market value of the company’s debt
V=E+D (Total value of equity and debt)
Re=Cost of equity
Rd=Cost of debt
Tc=Corporate tax rate
With that in mind, the first part of the formula is calculating the cost of equity, based on the percentage equity represents of the total capital portfolio. The second part of the formula does the same for debt, adjusting for the tax shield benefit from debt.
To start, we need to collect the assumptions needed. Let’s assume the following:
E=$50,000,000 (Combined value of shares outstanding)
D=$25,000,000 (Bonds, loans, and lines of credit extended)
V=$75,000,000 (Total value of equity and debt)
Re=8% (Cost of equity, the topic for another post, it’s usually more expensive than debt)
Rd=5% (Cost of debt, weighted average of all interest rates)
Tc=22% (Corporate tax rate)
From there, we lay out the formula and use Excel to run the calculations.
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