Weighted Average Cost Of Capital (WACC) refers to the cost of capital which is calculated by multiplying the cost of specific sources and the weight or contribution of those sources in the total capital of the company.
Below is the method for calculating WACC formulas is:
WACC = (E/V × Re) + ((D/V × Rd) × (1 – T))
E = market value of the firm’s equity (market cap)
V = total value of capital (equity plus debt)
D = market value of the firm’s debt
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate
It is calculated for:
- To establish the firm opportunity cost of capital for capital budgeting purposes.
- To know the overall cost of capital.
- Establishing project specific hurdle rates.
- WACC is calculated by applying the following steps
- Identification of capital sources.
- Determination of required rate of return and calculating the specific cost of capital.
- Calculating the weight of specific sources of capital.
- Calculation of WACC.