WACC Formula – Cost of Capital

The WACC formula or weighted average cost of capital formula is used to take the weighting of both equity and debt into account to arrive at an average cost of capital funding for the business.

A business normally uses both equity and debt to provide capital funding. The cost of capital is therefore a combination of the cost of equity and the cost of debt. The overall cost of capital for the business will change depending on how much weighting each type of capital has.

The WACC formula can be stated as follows:

WACC = Cost of equity x E/(E+D) + Cost of debt x (1-tax rate) x D/(E+D)
Variables used in the formula
Cost of equity = % rate of return on equity
Cost of debt = % cost of debt
E = market value of the equity of the business
D = market value of the debt of the business
E/(E+D) = % of capital funded by equity
D/(E+D) = % of capital funded by debt
Tax rate = % tax rate

WACC Formula Example

Suppose a business is 75% funded by equity and 25% funded by debt, and the rate of return on equity of the business is 15%, the cost of debt is 6%, and the tax rate is 30%.

The WACC formula can be used to give the weighted average cost of capital as follows:

Cost of equity = 15%
Cost of debt = 6%
Percentage of equity = E/(E+D) = 75%
Percentage of debt = D/(E+D) = 25%
Tax rate = 30%
WACC = Cost of equity x E/(E+D) + Cost of debt x (1-tax rate) x D/(E+D)
WACC = 15% x 75% + 6% x (1-30%) x 25%
WACC = 12.30%

The WACC formula shows that the weighted average cost of capital for the business is 12.30%. This value can be used for example, as the discount rate when carrying out project valuations using the net present value method, such as that used in our freemium model calculator.

WACC Formula and Debt Equity Ratio

The formula for WACC above can be rearranged to express the weighted average cost of capital in terms of the debt equity ratio as follows.

WACC = Cost of equity x 1/(1+D/E) + Cost of debt x (1-tax rate) x (D/E)/(1+D/E)
Variables used in the formula
Cost of equity = % rate of return on equity
Cost of debt = % cost of debt
D/E = Debt equity ratio
Tax rate = % tax rate

Or alternatively to express the debt equity ratio.

D/E = Debt Equity ratio = (Cost of equity – WACC) / (WACC – Cost of debt x (1-tax rate))

WACC Debt Equity Formula Example

Suppose a business has a debt equity ratio of 0.65, and the rate of return on equity of the business is 12.1%, the cost of debt is 5.5%, and the tax rate is 30%.

The WACC Debt Equity formula can be used to give the weighted average cost of capital as follows:

Cost of equity = 12.1%
Cost of debt = 5.5%
Debt equity ratio = 0.65
Tax rate = 30%
WACC = Cost of equity x 1/(1+D/E) + Cost of debt x (1-tax rate) x (D/E)/(1+D/E)
WACC = 12.1% x 1 / (1+0.65) + 5.5% x (1-30%) x 0.65 / (1+0.65)
WACC = 8.85%
WACC Formula – Cost of Capital June 7th, 2018Team

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