How to Calculate the Weighted Average Cost of Capital (WACC)

An explanation and example using a real company

The weighted average cost of capital (WACC) helps us to determine how much it costs a firm to finance its operations. This is a crucial measurement because it helps us to determine whether a company's return on invested capital (ROIC) is more or less than the capital itself cost to acquire.

A company is seen as using its capital efficiently if the WACC is less than the ROIC, and the higher the difference the more efficient it is. For example, if a company borrows cash at an interest rate of 5% and gets a return on that cash of 10% then it has made a profit on the cash of 5%. The company can be said to have created 5% wealth on the borrowed cash. If, however, the company only makes 3% return on the cash, then it has destroyed wealth by 2%.

The higher the ratio of ROIC to WACC the better. It is also useful to measure this ratio in comparison to other companies in the same sector.

Weighted average cost of capital (WACC)

The weighted average means we need to take the relative weights of each component of the capital. For example, if a company borrows 100 million dollars at 5% interest, 50 million at 3% interest and 450 million at 10% then the average interest rate is 6%. However, this figure ignores the fact that the majority of the money was borrowed at 10%, but by 'weighing' the average according to the size of the loan we can get a more accurate measure of how much interest the company is paying. By calculating the weighted average we get a more accurate cost of cash of 8.58%.

Non-weighted average = 5+3+10 = 6%

Weighted average = [(100×5)+(50×3)+(450×10)] / (100+50+450) = 8.58%

If the company is financed with only debt and equity we can calculate the WACC with the following formula:

• E = market value of equity
• D = market value of debt
• V = E + D
• Re = cost of equity
• Rd = cost of debt
• Tc = corporate tax rate

A worked example of calculating WACC using 3M's annual report

Let's use a real world example of the company 3M. We will work out its WACC by using figures from the 2020 annual report which can be downloaded here.

E = market value of equity

(shares outstanding × market price).

• Shares outstanding is 576,252,992.
• Market price for December 2020 is 173.57.

Therefore market value of equity is (576252992 × 173.57) = 100020231821.44 (10.02) billion.

D = market value of debt

The market value of debt can be tricky to work out because not all debt values are listed in the balance sheet and therefore must be calculated. This calculation takes all the company's debt and calculates it as if it is one coupon bond, so we can get a useful value. We have performed a detailed calculation and explanation of market value of debt for 3M over here.

Market value of debt = 15.058 billion

Re = cost of equity

The cost of equity in this scenario, represents the required return 3M must make on its investments to offset the opportunity cost of investing in something less volatile. We have performed this calculation and explained it in detail here.

The calculation for cost of equity, linked above, gives us two measures for cost of equity. One measure is the dividend capitalization model and the other uses the capital asset pricing model (CAPM). We will use the CAPM result (for more details check the article above):

Re = 9.5%

Rd = cost of debt

The cost of debt is the average interest rate that a company pays on all of its debt. This interest rate is calculated by averaging all interest rates related to loans and bonds the company has. There is more than one way to calculate the cost of debt for a company and a detailed calculation for cost of debt has been performed for 3M here.

NOTE: we use the after-tax cost of debt using the weighted average interest rate for all current debts. Details of this calculation is linked above.

Rd = 2.14%

Tc = corporate tax rate

We have to manually calculate the corporate tax rate as it is not directly given on the annual report. We take the income tax expense and divide it by the earnings (income before tax) to arrive at the effective tax rate. These values can be found on the income statement of the report.

• Income tax expense is 1.318 billion.
• Earnings before tax is 6.711 billion.
• Tax rate = (1318 / 6711) × 100 = 19.64%

Now we can calculate the WACC

• E = market value of equity = 10.02 billion
• D = market value of debt = 15.058 billion
• V = E + D = 25.078
• Re = cost of equity = 9.5%
• Rd = cost of debt = 2.14%
• Tc = corporate tax rate = 19.64%

WACC = (10.02/25.078 × 9.5/100) + (15.058/25.078 × 2.14/100 × (1 - 19.64/100)) = 0.0482... or 4.82%

NOTE: for each of the percentage values in this equation we divide by 100. The result is multiplied by 100 to show it in percentage form.

WACC = 4.82%

Summary

Calculating the WACC for 3M is a long and laborious process but a very good exercise as it gives insight into all the inputs. We should also note that the result is an approximation because some inputs themselves are approximations. Miller writes in the Quarterly Review of Economics and Finance that the WACC is a 'linear approximation of a nonlinear relationship'.

Henderson et al. also point out, like Miller, that the WACC is at best an approximation but that it is a pretty good approximation and perhaps the best measure we can hope to get (as an individual investor).

References

Richard A. Miller - The weighted average cost of capital is not quite right

Glenn V. Henderson, Jr. - Weighted Average Cost of Capital, Financial Management Vol. 8, No. 3 (Autumn, 1979), pp. 57-61