What is weighted average cost of capital (WACC)? Formula of WACC

Weighted Average Cost of Capital (WACC) is the cost of capital calculated by an enterprise based on the proportion of types of capital used by the enterprise.

What is WACC?

Weighted Average Cost of Capital in English is Weighted Average Cost of Capital, abbreviated as WACC. The average cost of capital is the cost of capital calculated by an enterprise based on the proportion of types of capital used by an enterprise. Financing capital of the business includes: ordinary shares, preference shares, bonds, debt

Meaning of WACC

Usually in real business operations, to meet the capital needs for the investment process, enterprises have to mobilize and use many different sources of funding and each funding source has different costs of capital.

Therefore, it is necessary to determine the average cost of capital to make the right financial decisions.

WACC formula

WACC = (E/V) x K+ (D/V) x KD

Inside:

KE: Cost of equity (1)
KD: Cost of debt (2)
E: Market value of Equity
D: Market value of Debt
V: Total long-term capital of the enterprise (V = E + D)
Tax: CIT rate
# Note: The capital structure used (E / V or D / V) must be the optimal capital structure. Is determined by the market value of the business.

Note:

It should be noted that, when calculating the average cost of capital, the after-tax cost of capital for each individual funding source should be the after-tax cost of capital.

In addition, the capital structure used is the optimal capital structure, and it is often determined by the company’s market price.

For simplicity, one can also use the book value capital structure in terms of if the book value is also close to the market value.

A joint stock company has a total capital of 8,000 million VND and is formed from the following funding sources:

STT Resources Value Density (%)
1 Loans 3,600 45
2 Preferred shares 160 2
3 Equity (ordinary equity and retained earnings) 4,240 53
Total 8,000 100

The above capital structure is considered optimal.

In the next year, the company plans to raise VND 2,000 million for investment and the capital mobilization will be done according to the optimal capital structure, in which the company expects the profit to re-invest to be 1,060 million. .

According to calculations, the pre-tax cost of debt is 10% / year, the cost of using preferred shares is 10.3% / year, the cost of using the retained profit is 13.4%.

From there, the average cost of capital for the company’s investment can be calculated:

– After-tax cost of loan: 10% x (1 – 25%) = 7.5%

– Average cost of capital:

WACC = (45% x 7.5%) + (2% x 10.3%) + (53% x 13.4%) = 10.55%

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