Weighted Average Cost of Capital – Examining the Capital Structure of a Corporation
Weighted Average Cost of Capital is a calculation of the overall cost of capital used by a corporation and is an average representing the total return (in percent) that is expected of an organization on all its assets, debts and owner’s equity to maintain its current stock price & valuations. Weighted Average Cost of Capital weighs in all items that play a role in the corporation’s capital structure including common and preferred shares, bonds, and other long term debts.
In order to calculate the weighted average cost of capital, we must first examine the capital structure of the company we are analyzing. In terms of corporate finance, capital structure refers to how a corporation finances it assets and its business operations; either through the use of long term debt, common shares or preferred stock (also known as shareholder’s equity) or other hybrid securities. Weighted Average Cost of Capital becomes especially important when the capital structure of a firm involves both debt and equity financing. In this example, we will look at the three most common types of financing included in capital structure:
Each of these components has a cost associated with it. Use of Weighted Average Cost of Capital comes usually at a time during merger and acquisition. Some financial analysts look at WACC objectively to examine the capital structure of the company and whether it is running at an optimal rate, or things could be tweaked for bettering the value provided to shareholders, as well as to optimize the value of the organization’s finances. The recommendations made by financial analysts after examining capital structures include either carrying more debt, less debt or issue more common/preferred shares, pay off debt and issue more equity, or trade debts with different interest rates.
Steps for Calculating Weighted Average Cost of Capital
There are three steps for calculating the WACC of an organization.
The formula for WACC is:
Example of Weighted Average Cost of Capital in Tabular format
Below is graphical representation of the market value of the weighted average cost of capital calculations. It shows how the capital structure is divided in to 3 parts consisting of $480,000 debt (9% in blue), $650,000 of preferred stock (12% in pink) and $4,200,000 of common stock (79% in green).