WACC is an acronym for “Weighted Average Cost of Capital” and it describes what, on average, a corporation must pay out to all its security holders. This is the average cost of the financing on a corporation’s assets. WACC is also the minimum amount of return a corporation must earn in order to satisfy all the creditors within its capital structure. WACC is of great importance when determining whether or not an investment has the potential for positive returns.

Determining a corporation’s WACC becomes more complex as the number of capital components involved in the financing increases. By taking a weighted average of a corporation’s total interest, we are able to determine how much return is required on an on-going basis to satisfy all investors providing funds.

In order to calculate a corporation’s weighted average cost of capital, the following elements are required:

• Cost of Equity (Re)
• Cost of Debt (Rd)
• Market Value of Equity (E)
• Market Value of Debt (D)
• Total Debt plus Equity (V)
• Percentage of Financing Represented by Equity (E divided by V)
• Percentage of Financing Represented by Debt (D divided by V)
• Corporate Tax Rate (Tx)

Using the above values, WACC can be calculated as follows:

WACC = [(E / V) X Re] + [(D/V) X Rd X (1 – Tx)]

By calculating a corporation’s WACC, management can use this weighted average to see how much interest is being paid for every dollar of financing it has on the books.

For a more in-depth method of calculating WACC, have a look at the following article that discusses the true definition of WACC as well as some misconceptions and common errors made when calculating WACC. This paper explains the true meaning of weighted average cost of capital and therein 7 errors due to “not remembering the definition of WACC”. The seven errors mentioned in the article include the following:

• using the wrong tax rate
• using the book value of debt and equity instead of the correct valuation
• assuming a capital structure that is neither the current nor forecasted structure
• failure to satisfy the “time consistency formulae” (see the paper)
• assuming the incorrect return on assets
• using the wrong formula to calculate WACC (two methods are given in the paper)

The paper also discusses the challenges with calculating the value of a tax shield (VTS) and proposes a method to address said challenges.

Determining your corporation’s capital structure is done by calculating the percentage of the total funding that each component represents. By analyzing a corporation’s financial statements, we are able to compile a list of all the capital components on the books. Taking into account all capital components that contribute to the overall capital structure, we are able to calculate the percentage of the total capitalization represented by each capital component. And digging deeper, we will uncover the corporation’s leverage which is described by the ratio of debt financing to equity financing.

Understanding a corporation’s capital structure is necessary to determine which of the many available options is the most fiscally responsible to pursue. Financing with equity versus debt has different capital costs and, as such, will have significantly different long-term effects on the health of a corporation’s finances.

The steps to determining your Capital Structure are as follows:

1. Identify all of the corporation’s capital components by examining the most recent financial statements. Compile a list of all debt and equity, including retained earnings, common shares, debt financing and contributions.
2. Calculate the sum total of all debt and equity you have identified. This figure should equal the sum total of all the corporation’s assets.
3. Take each component of the corporate structure and divide it by the sum total of all components, as calculated in step 2. These calculated figures represent what each source of capital’s percentage is relative to the sum total of the corporate structure.
4. These percentages, if calculated on a regular base, can be used to monitor what mix of debt versus equity a corporation currently holds on its books.

Debt financing is the most costly source of capital versus equity. By monitoring a corporate structure over time and incorporating mezzanine debt into the structure, an effective and fiscally responsible capital structure can be planned and achieved.

A

Acquisition – The acquiring of one corporate entity by another through the exchange of funds or securities.

Alternatives – A form of debt relief referred to in contemporary times as debt restructuring or forbearance.

Asset – A property or resource that holds financial value and is owned or controlled by an individual, corporation or country.

B

Bootstrap Transaction – An alternative term for Leveraged buy-out.

C

Capital structure – The description and relationship of how a corporation’s financing sources are structured.

Collateral – Assets or properties with monetary value that are offered as security in exchange for funds when raising debt finance.

Consolidation – The merger of several smaller corporate entities into one larger organization.

D

Debt Financing – Financing that is secured against bonds, bills or notes, promising the repayment of the principal with interest back to the creditor.

Debt Restructuring – The process of altering the terms of a debt agreement in order to achieve a financial advantage.

E

Expansion – Using capital and financial resources to expand and grow a corporation either in volume, product offerings or expanded territory.

Equity – A form of capital that represents the value of an ownership stake or interest in a property, corporation or asset.

Equity Financing – Financing that is raised in exchange for ownership interest in the corporation.

F

Finance – Describes the process by which assets, investments, debts, capital, money and banking are organized and managed.

Forbearance – The postponement of obligated payments on a financial debt in order to allow the debtor a period of time to make-up for outstanding payments.

H

HLT – An acronym for highly-leveraged transaction (HLT) which is an alternative term for leveraged buy-out.

L

Leveraged Buy-Out (LBO) – When a corporation is purchased through highly leveraged financing by way of borrowing against assets to raise the necessary purchasing funds.

M

Merger – The consolidation of two corporate entities through the exchange or transfer of securities.

Mezzanine Debt – A form of hybrid capital that is senior only to common shares and may incorporate certain characteristics of both debt-based and equity-based financing.

R

Recapitalization – The re-organization of a corporation’s capital structure.

S

Senior Debt – The first level of a corporation’s liabilities which is paid out first ahead of all other creditors.

W

WACC – An acronym for “Weighted Average Cost of Capital” which describes the average amount a corporation must pay out to its security holders in the form of interest.

Working Capital (WC) – A financial metric that determines a corporation’s operating liquidity which is calculated by subtracting a corporation’s current liabilities from its current assets.

Capital structure describes how a corporation finances its assets. This structure is usually a combination of several sources of senior debt, mezzanine debt and equity. Wise companies use the right combination of senior debt, mezzanine debt and equity to keep their true cost of capital as low as possible. Depending on how complex the structure, there may in fact be dozens of financing sources included, drawing on funds from a variety of entities in order to generate the complete financing package. Capital structure is what describes the relationship of these financing sources as they appear on the corporation’s balance sheet.

Examples of capital sources that may be included in a corporation’s capital structure are:

• Working Capital
• Equity
• Senior Debt
• Mezzanine Debt
• Alternatives