WACC

Weighted average cost of capital (WACC) is the return that the providers of a company's capital require. Calculating it requires knowing the rates of return required focr each source of capital. See cost of capital.

The cost of capital will be different for each source of capital and class of securities a company has, reflecting the different risks. The WACC is the weighted average of the costs of each of the different types of capital. The weights are proportion of the company's capital that comes from each source. In a simple case:

WACC = D/(D + E) × i + E/(D + E) × r

where i is the interest rate,
r is the required return on equity,
D is the amount of debt capital,
and E is the amount of equity capital.

This is not complete. WACC unifies the costs of sources of capital that are subject to different tax treatments. This needs to be adjusted for. It is particularly important to adjust the cost of debt capital (usually tax deductible) to put it on the same basis as equity capital.

To do this we need to adjust the tax deductible costs by correcting the cost of debt for the tax savings made. This means the calculation becomes:

WACC = D/(D + E) × 1/(1 - t) × i + E/(D + E) × r

where t is the tax rate.

This may need to be adjusted further where there is more than one type of debt or equity capital. To take a common example supposedly debt D is actually split into senior debt and subordinated debt, then:

WACC = D1/(D + E) × 1/(1 - t) × i1 + D2/(D + E) × 1/(1 - t) × i2 + E/(D + E) × r

where D1 is the amount of senior debt,
D2 is the amount of subordinated debt,
D = D1 + D2,
i1 is the YTM of the senior debt and
i2 is the YTM of the subordinated debt.

More complex forms of capital such as convertible debt would require considerably more complex adjustments.

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