Weighted Average Cost of Capital

Weighted Average Cost of Capital: (WACC), is usually compared with the actual return on capital earned by a company to determine how much value (if any) management is adding for shareholders (Economic Value Added-EVA). The calculation “weights” the cost of equity with the percentage of share that equity represents in the capital structure, and the cost of debt with the percentage share it represents, to produce a composite figure.

WACC = Cost of equity X (Market-cap/Enterprise value) + Cost of debt (Debt/Enterprise value)

• Cost of Equity: the risk-free rate of return plus the “equity risk premium” adjusted for the “systemic risk” involved in the equity.
• Risk-free Rate of Return: redemption yield on a long-term US Treasuries.
• Equity risk premium: the amount by which the return on equities exceeds the risk-free rate of return over the longer-term.
• Systemic risk (beta): the degree to which the shares of the stock in question are more or less volatile than the market as a whole. A share with a beta 1.5 would rise 15% if the market rose 10%.
• Cost of equity: is always calculated as a monetary value.
• Cost of debt: the monetary value that equates to the yield to maturity on the company’s debt, since this will reflect the market’s view of the risk of the debt relative to a risk-free band.
• Market-cap: stock market value (#shares X share price).
• Enterprise Values: adjusted market-cap for a balance of cash or debt.

This calculation, as you can see, has a lot of variables and assumptions–which means the person doing the calculation has plenty of room for making errors and will thus have less confidence in the final result used alone to make any decisions. The calculation is nonetheless interesting–especially the idea of discounting future earnings by an appropriate risk-free rate of return–which will be an essential concept in Prof Sage’s Intrinsic Value calculation (Discounted Cash Flow).