Companies need capital in order to run their operations. Because of this, they raise money either through equity (issuing shares) or through debt financing (bonds/loans). However, raising money isn't free. There is a cost of issuing debt, and a theoretical cost of issuing equity. WACC is a weighted average of cost of debt and equity. It is an important calculation for valuing stocks because a company's WACC is often used as a discount rate for valuation.
What is WACC?
As stated above, WACC is the weighted average cost of capital (after-tax) a company can expect to pay to finance its operations. This includes the cost of any kind of debt, common shares, and preferred shares. Therefore, in order to calculate WACC, we need to find out the company's cost of debt, cost of equity, cost of preferred equity if they have preferred shares, the weight of each of those three, and the company's tax rate.
Step 1: How to Calculate the Cost of Debt
Let's start with the cost of debt. The three things you need to know for this calculation are: Interest expense in a company's latest annual report (or trailing twelve months), total debt from their annual report (or TTM), and their tax rate. Then, to apply it to WACC for a weighted calculation, you need to find out how much of their capital structure is made up of debt.
Lets take Apple Inc. for example:
Total Debt: $114,483,000,000
Interest Expense: $3,576,000,000
To find the pre-tax cost of debt, you divide their interest expense by total debt. This will give you 3.11% as your answer. Then, you calculate their effective tax rate. To find this out, you divide their income tax expense by their income before tax. Another way to find the effective tax rate is to search for it in their filings on sec.gov. In their filings, Apple states that their effective tax rate is 15.9%, but lets calculate it anyways.
Income tax expense: $10,481,000,000
Income before tax: $65,737,000,000
Effective tax rate:
10,481,000,000/65,737,000,000 = 0.159 or 15.9%
Now that you have their pre-tax cost of debt, and their tax rate, you can calculate their after-tax cost of debt. To calculate this you: subtract 15.9 (tax rate) from 100 to get 84.1. Next, you multiply the pre-tax cost of debt by 0.841.
After-tax cost of debt = 3.11 (0.841) = 2.61%
The reason the after-tax cost of debt is less than their pre-tax cost of debt is because interest expense is a tax write-off, so companies actually save some tax money from having debt.
Step 2: How to Calculate Cost of Equity
Cost of equity is more straight forward to calculate than cost of debt, but it can be a subjective calculation as equity does not have a tangible cost that you can calculate. Instead, it is the theoretical opportunity cost of investing in the company's equity.
Cost of equity is often calculated using the Capital Asset Pricing Model (CAPM).
Here is the formula below:
It may seem complicated at first glance but it is as simple as just plugging in a few numbers. Plus, there are many CAPM calculators online that do the calculations for you as long as you input the numbers.
Let's do an example for Apple Stock:
The risk free rate is the annual return you can make on a "risk-free" investment, usually the 10-year US bond, which is currently around 0.64%. You can easily search up "US 10 year yield" and you will find the current yield.
The S&P 500 on average returns about 10% a year, so we put 10% as the expected return of the market. 10% may be a bit on the high range, which would give you a higher cost of equity. So if you personally don't agree with 10%, some people use lower numbers such as 7%. It is generally in the 7-10% range. Alternatively, you can use Duff & Phelps' recommended equity risk premium (expected return - risk free rate) which you can find here.
Beta for specific stocks can be found on websites such as Yahoo Finance. Although we don't like traditional beta, it is what you would use if you want to do the CAPM calculation traditionally. According to Yahoo Finance, Apple's beta is 1.18.
If you put those numbers into the formula it would look like this:
Ra = 0.64 + 1.18 (10-0.64)
This answer would indicate that Apple's cost of equity is 11.68%.
Step 3: How to Calculate the Cost of Preferred Equity
Some companies issue preferred shares, which act like regular shares in some ways and like debt in other ways. The main reason people buy preferred shares is because they pay dividends that are higher than the dividends they would receive on the common shares and because preferred dividends are safer than dividends on common shares (preferred dividends are higher priority payments than common share dividends).
That being said, for the company, there is a cost associated with this. The cost of preferred equity is essentially the current dividend yield on the preferred shares. The formula below applies if the company has perpetual preferred shares that are non-callable or non-convertible.
Here is the formula to calculate the cost of preferred equity below:
If we're still using Apple as an example, they don't have any preferred shares. Most companies don't have preferred shares, and if they do, it's usually an immaterial amount that won't affect the cost of capital too much. But in case you encounter a company that has a large amount of preferred shares, this is how you would use the formula:
Company Ticker: XYZ
Preferred Stock Price: $24 per share
Annual Dividend: $1.50 per share
Cost of preferred equity = 1.50/24
= 0.0625 or 6.25%
Step 4: Find the Weight of Debt, Equity, and Preferred Equity
After you've calculated a company's cost of debt and cost of equity, as well as cost of preferred equity if applicable, you then need to find the company's market cap (also known as equity value). Next, you need to find its total debt. If your company has preferred shares, you also need to find the value of the preferred shares (more on that after this Apple example).
Let's still use Apple for example:
Market Cap: $1,671,000,000,000
Total Debt: $114,483,000,000
Market cap + Debt = $1,785,483,000,000
To find the weight of equity you divide the market cap by (market cap + debt).
1.671/1.785 = 93.6%
To find the weight of debt, you divide the total debt by (market cap + debt)
114/1785 = 6.4%
This adds up to 100%. Apple's capital structure is 93.6% equity and 6.4% debt. Now you can use those 2 numbers for the formula.
Here is the formula for WACC:
Using Apple's numbers and ignoring the preferred shares part of the calculation because they have none, the calculation would look like this:
WACC = (6.4% x 3.11%) (1-15.9%) + (93.6% x 11.6%)
= 0.11 or 11% WACC
Numbers used for formula:
Weight of debt: 6.4%
Pre-tax cost of debt: 3.11%
Tax Rate: 15.9%
Weight of Equity: 93.6%
Cost of Equity: 11.6%
Note: If using the after-tax cost of debt (2.61% that we calculated above) you can remove (1-t) from the formula.
This would make the new formula:
WACC = (6.4% x 2.61%) + (93.6% x 11.6%)
= 0.11 or 11% WACC
How to Calculate Weight of Preferred Shares if Applicable
If the company you are analyzing has preferred shares, you need to calculate the weighting.
Here's how you would do it:
Market Cap: 100 million
Debt: 20 million
Preferred shares outstanding: 1 million
Price per preferred share: $25
Value of preferred shares: 25 million
Market cap + debt + value of preferred shares: 145 million
25,000,000/145,000,000 = 17.2% weight for preferred shares.
Then, weight of equity would also be found by dividing the market cap by 145 million, which would give you 69%.
Lastly, you're left with debt which would simply be 20 million divided by 145 million, which is 13.8%.
Note: In the Apple example above, we used market cap + debt as the denominator because they have no preferred shares. If a company has preferred shares, the denominator becomes market cap + debt + value of preferred equity, just like in the most recent company XYZ example.
Now you know how to calculate WACC. This will come in handy for valuation methods such as Discounted Cash Flow (read more about DCF by clicking here), or other valuation methods where WACC is used as a discount rate.
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