Finance is a very large industry with many roles and functions, which is why it is hard to generalize about what makes a successful financial career. Extroverts and smooth talkers find sales roles fit them well, while math junkies may veer towards quant research roles. But there are more aspects to finance than just these two, and everyone from the most sophisticated stats expert to creative but math illiterate writers can find their position in the big tent that is this sector.
There are a few basic premises that everyone must be aware of, and a few basic formulas that one needs to be familiar with enough to look up, if not actually memorize. The weighted average cost of capital (WACC) is just such a formula. This rather basic tool is essential in corporate finance, equity research, credit research, investment banking, and many other parts of finance as well. Understanding its function, how to calculate it, and how to use it can give an entrant to the field a massive advantage.
So, what is WACC? Simply put, when a company borrows money for any reason, that borrowing has a cost. Companies can borrow two ways, either by selling equity or selling debt; both have costs and those costs typically differ, and the WACC formula is a way of combining those two to see the true actual cost of borrowing for a firm.
Setting the formula up is easy.
WACC = ((E/E+D)rE)+(((D/E+D)rD)*(1-t))
Where:
E = equity value
D = debt value
rE = cost of equity
rD = cost of debt
t = corporate taxation rate
Let’s take an entirely hypothetical company for this example, Firm X, with a 5% taxation rate. t = 0.05.
Next we can get the cost of debt (rD) by calculating the total interest expense for the firm for one year, then divide that by the total value of all liabilities on the firm’s balance sheet. Let’s say rD = 284m / 20,230m = 1.4%.
Cost of equity (rE) is a bit different; here the formula is risk free rate + (beta * equity risk premium). This is easier than it looks. We start with the risk-free rate (typically the 10-year Treasury yield) of 4.125%, a beta of 0.811 (derived from comparing the stock’s volatility to the S&P 500; most data providers give this number), the equity risk premium (how much do we expect from the market minus the risk free rate). The latter is the most contentious and subjective, but let’s say we expect the 10-year annualized sector return plus a 3% premium, meaning this is 9.2%.
Now we can say that rE = 4.125% + (0.811*9.2%) = 11.6%.
Now, E is easy—that’s just a public company’s market capitalization (for simplicity’s sake, although in reality this can be more complicated), which we’ll say is $30 million. D is even easier; it’s just the total market value of the firm’s liabilities (listed as “total liabilities” on a firm’s balance sheet in a 10-Q or 10-K). We already know this is 20.23m for our example.
Now we have everything for our formula:
WACC = ((30,000,000/30,000,000+20,230,000)11.6%)+((20,230,000/30,000,000+20,230,000)1.4%)*(1-0.05) = 5.4%.
Note how in this example the WACC is low thanks to the low cost of debt, and the calculation gives us a pretty clear actionable decision on whether to take out debt or issue equity, how much of a return we need to make leverage profitable, and so on. WACC is a powerful and simple tool for anyone analyzing financial decisions.