The Weighted Average Cost of Capital

What Does "Cost of Capital" Mean?

"Cost of capital" is defined as "the opportunity cost of all capital invested in an enterprise."
Let's dissect this definition:
Opportunity cost is what you give up as a consequence of your decision to use a scarce resource
in a particular way.
All capital invested is the total amount of cash invested into a business.
In an enterprise this refers to the fact that we are measuring the opportunity cost of all sources of
capital which include debt and equity.
How Do We Calculate a Company's Weighted Average Cost of Capital?
We calculate a company's weighted average cost of capital using a 3 step process:
1. Cost of capital components. First, we calculate or infer the cost of each kind of capital that the
enterprise uses, namely debt and equity.
A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the
company's debt, adjusted for the tax-deductibility of interest expenses. Specifically:
The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal
tax rate in %)
We enter the marginal corporate tax rate in the worksheet "WACC."
B. Equity capital. Equity shareholders, unlike debt holders, do not demand an explicit return on their
capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific
company, because they could invest in an alternative company with a similar risk profile. Thus, we
infer the opportunity cost of equity capital.
We can do this by using the "Capital Asset Pricing Model" (CAPM). This model says that equity
shareholders demand a minimum rate of return equal to the return from a risk-free investment plus
a return for bearing extra risk. This extra risk is often called the "equity risk premium", and is
equivalent to the risk premium of the market as a whole times a multiplier--called "beta"--that
measures how risky a specific security is relative to the total market.
Thus, the cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium).
2. Capital structure. Next, we calculate the proportion that debt and equity capital contribute to the
entire enterprise, using the market values of total debt and equity to reflect the investments on
which those investors expect to earn a minimum return.

3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion
that each contributes to the entire capital structure. This gives us the Weighted Average Cost of
Capital (WACC), the average cost of each dollar of cash employed in the business.

Case Study: Gateway Construction Pty Ltd. (India)

To demonstrate how to calculate a company's cost of capital, we will use the Gateway case study.
1. Cost of capital components. Gateway draws upon two major sources of capital from the capital
markets: debt and equity.
A. Cost of debt capital. Gateway had debt of $8.5 million. Enter this figure in the appropriate cell of
worksheet "WACC."

Our first step in calculating any company's cost of capital is to consult the relevant annual report.
This document tells us that Gateway has two components to its total debt of $8.5 million:
Regular debt.
Capital leases. Gateway also has "capital leases." A capital lease is a debt-like agreement in
which a firm agrees to pay fixed amounts to someone who leases them land or equipment. \
Because there are two kinds of debt with different interest rates, we have to weight the different
interest rates associated with each kind of debt by the relevant proportion of debt that each
comprises. In this case, the weighted pre-tax cost of debt would be equivalent to 11.5%. Enter the
pre-tax cost of debt in cell C5 of worksheet "WACC."
However, we are not done yet. We noted above that we have to adjust for the tax-deductibility of
interest expenses, which lowers the cost of debt according to the following formula:
After-Tax Cost of Debt Capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal
tax rate)
Given Gateway's marginal tax rate of 30%, the company's after-tax cost of debt equates to 11.5% x
(100% minus 30%), or 8.1%. We see this calculation in the worksheet "WACC."
Please note that in this example, we have used a company's actual cost of debt as a proxy for its
marginal cost of long-term debt. A company's marginal cost of long-term debt may be better
estimated by summing the risk-free rate and the "credit spread" that lenders would charge a
company with a specific credit rating.
B. Cost of equity capital. We noted above that:
Cost of Equity Capital = Risk-Free Rate + (Beta times Market Risk Premium).
To calculate any company's cost of equity capital, we need to find a reliable source for each of
these inputs:
1. Risk-free Rate. We suggest using the rate of return on long-term (ten-year) US government
treasury bonds as a proxy for the risk-free rate. (Or German Bunds for Euros). We enter this data
point in cell C4 of worksheet "WACC."
Sources for this include:
FT.com - the Financial Times web site
Reuters.com

2. Beta coefficient. We enter this data point in cell C8 of worksheet "WACC."

In this case we have selected the industry beta for "Building - Heavy Construction" from the the
worksheet "Industry Betas, obtained from damodaran.com. Enter 1.66 for Gateway's beta.
There are a variety of sources available for obtaining the beta coefficient for a particular company.
Yahoo. Yahoo offers free beta estimates through its Company Profile service. Click here to see
Gateway's Company Profile on Yahoo.
Bloomberg. Free beta estimates from Bloomberg can be accessed online. Bloomberg's estimate
of Gateway's current beta can be accessed here.
Damodaran.com for industry betas - helpful for private companies and emerging markets
3. Equity Risk Premium. Forward looking approaches, as well as more recent historical data,
suggest an equity risk premium in the 3 to 5 percent range. Additional factors can raise this, as
noted below. We use an Equity Risk Premium estimate of 7.5% for this family-dominated Indian
company. We enter this data point in cell C7 of worksheet "WACC."
In addition to the calculated risk premium, additional required return may be needed for:
- Private equity illiquidity risk
- Minority shareholding/corporate governance risk premium
- Country risk
For those interested in looking at historical equity risk premia, we refer you to the following online
resources:
Ibbotson Associates. Ibbotson sells a report on historical risk premia over time on its website. The
report can be purchased.
Aswath Damodaran. Valuation expert Professor Damodaran of NYU's Stern School of Business
has published data as well as an informative article on equity risk premia that can be downloaded
free of charge.

To continue with our Gateway case study, we used the following estimates for these three factors:
Risk-free rate of 4%.
Beta coefficient of 1.66.
Equity risk premium of 7.5%.
Using these estimates, Gateway's cost of equity capital = Risk-Free Rate + (Beta times Market Risk
Premium).= 4.00% + (1.66 x 7.5%), or 16.5%. We see this calculation in the results section of
worksheet "WACC."

3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion
that each kind of capital contributes to the entire enterprise. This gives us the Weighted Average
Cost of Capital (WACC), the average cost of each dollar of cash employed in the business.

To review, Gateway's after-tax cost of debt is 8.1% and its cost of equity is 16.5%. The market
value of Gateway's debt is equal to $8.5 million and the market value of Gateway's equity is $45
million. The value of equity can be obtained from the shares outstanding and share price in cells
C12 and C13 in worksheet "WACC." Alternatively, for private companies, the value of the business
may be computed using comparables or a valuation model.
Gateway's weighted average cost of capital is thus 8.1% x 15.9% + 16.5% x 84.1% = 15.1%. You
can see this calculation in worksheet "WACC."
By Ian Giddy
Available as spreadsheet WACC_tutorial.xls on www.giddy.org
Acknowledgement: Adapted from http://www.expectationsinvesting.com/spreadsheets/WACC.xls

Inputs for WACC Calculation:

Risk free rate (%)
Yield-to-Maturity of debt (%)

4.00%
11.50%

Equity risk premium (%)

Beta of equity

7.50%
1.66

Corporate tax rate (%)

30%

Common shares (MM)

Share price ($)

10.0
4.50

Market value of debt ($, MM)

8.5

Industry Betas (these data can be updated from damodaran.com)

Industry
Advanced Materials/Prd
Advertising Agencies
Advertising Sales
Advertising Services
Aerospace/Defense
Aerospace/Defense-Equip
Agricultural Biotech
Agricultural Chemicals
Agricultural Operations
Air Pollution Control Eq
Airlines
Airport Develop/Maint
Apparel Manufacturers
Appliances
Applications Software
Athletic Equipment
Athletic Footwear
Audio/Video Products
Auto Repair Centers
Auto-Cars/Light Trucks
Auto-Med&Heavy Duty Trks
Auto/Trk Prts&Equip-Orig
Auto/Trk Prts&Equip-Repl
B2B/E-Commerce
Batteries/Battery Sys
Beverages-Non-alcoholic
Beverages-Wine/Spirits
Bicycle Manufacturing
Bldg Prod-Air&Heating
Bldg Prod-Cement/Aggreg
Bldg Prod-Doors&Windows
Bldg Prod-Wood
Bldg-Mobil Home/Mfd Hous
Bldg-Residential/Commer
Bldg&Construct Prod-Misc
Blood Collection Banking
Brewery
Broadcast Serv/Program
Building-Heavy Construct
Building-Maint&Service
Building&Construct-Misc
Cable TV
Capacitors
Casino Hotels
Casino Services
Cellular Telecom
Ceramic Products
Chemicals-Diversified
Chemicals-Fibers

Beta
1.51
1.09
0.25
1.64
0.97
1.44
1.11
1.28
1.40
1.04
1.34
0.99
1.11
1.29
1.07
1.06
1.01
1.14
1.87
1.33
1.31
1.13
1.01
0.76
1.02
0.88
1.13
1.71
1.18
1.32
1.86
1.49
1.40
1.70
1.19
NA
0.88
1.23
1.66
1.80
1.65
0.68
1.52
1.11
1.53
1.16
1.15
1.23
1.56

Chemicals-Other
Chemicals-Plastics
Chemicals-Specialty
Circuit Boards
Circuits
Closed-end Funds
Coal
Coatings/Paint
Coffee
Collectibles
Commer Banks Non-US
Commercial Serv-Finance
Commercial Services
Communications Software
Computer Aided Design
Computer Data Security
Computer Graphics
Computer Services
Computer Software
Computers
Computers-Integrated Sys
Computers-Memory Devices
Computers-Other
Computers-Peripher Equip
Consulting Services
Consumer Products-Misc
Containers-Metal/Glass
Containers-Paper/Plastic
Cooperative Banks
Cosmetics&Toiletries
Cruise Lines
Crystal&Giftware
Data Processing/Mgmt
Decision Support Softwar
Dental Supplies&Equip
Derivatives
Diagnostic Equipment
Diagnostic Kits
Diamonds/Precious Stones
Direct Marketing
Disposable Medical Prod
Distribution/Wholesale
Divers Oper/Commer Serv
Diversified Finan Serv
Diversified Manufact Op
Diversified Minerals
Diversified Operations
Drug Delivery Systems
E-Commerce/Products
E-Commerce/Services
E-Services/Consulting
Educational Software

1.48
1.31
1.23
1.34
1.60
0.33
1.34
0.97
0.82
0.70
1.33
0.97
0.98
0.85
2.05
1.45
1.38
1.02
1.36
1.53
1.20
1.51
1.03
1.36
1.28
1.54
1.09
1.05
1.03
1.00
0.67
0.53
1.27
0.90
0.41
NA
1.05
2.07
1.21
NA
1.00
1.26
1.44
1.39
1.48
1.55
1.49
0.77
1.30
1.18
1.36
1.21

Electric Products-Misc
Electric-Distribution
Electric-Generation
Electric-Integrated
Electric-Transmission
Electronic Compo-Misc
Electronic Compo-Semicon
Electronic Connectors
Electronic Design Automa
Electronic Measur Instr
Electronic Parts Distrib
Electronic Secur Devices
Electronics-Military
Energy-Alternate Sources
Engineering/R&D Services
Engines-Internal Combust
Enterprise Software/Serv
Entertainment Software
Environ Consulting&Eng
Explosives
Extended Serv Contracts
Feminine Health Care Prd
Filtration/Separat Prod
Finance-Auto Loans
Finance-Commercial
Finance-Consumer Loans
Finance-Credit Card
Finance-Invest Bnkr/Brkr
Finance-Investment Fund
Finance-Leasing Compan
Finance-Mtge Loan/Banker
Finance-Other Services
Firearms&Ammunition
Fisheries
Food-Baking
Food-Canned
Food-Catering
Food-Confectionery
Food-Dairy Products
Food-Flour&Grain
Food-Meat Products
Food-Misc/Diversified
Food-Retail
Food-Wholesale/Distrib
Footwear&Related Apparel
Forestry
Funeral Serv&Rel Items
Gambling (Non-Hotel)
Gas-Distribution
Gas-Transportation
Gold Mining
Golf

1.15
1.28
1.34
1.17
1.38
1.33
1.55
1.51
1.55
1.19
1.47
1.41
1.32
1.44
1.64
1.41
1.32
1.68
1.14
1.37
0.94
0.30
0.74
0.91
1.17
0.97
0.48
1.97
0.48
1.24
1.18
1.39
2.11
1.29
1.03
0.94
0.96
1.12
1.02
1.42
1.15
1.21
1.04
1.17
0.91
1.39
1.13
1.75
1.03
NA
1.52
0.93

Hazardous Waste Disposal

Health Care Cost Contain
Healthcare Safety Device
Home Decoration Products
Home Furnishings
Hospital Beds/Equipment
Hotels&Motels
Housewares
Human Resources
Identification Sys/Dev
Import/Export
Inactive/Unknown
Independ Power Producer
Industr Audio&Video Prod
Industrial Automat/Robot
Industrial Gases
Instruments-Controls
Instruments-Scientific
Insurance Brokers
Interior Design/Architec
Internet Applic Sftwr
Internet Brokers
Internet Connectiv Svcs
Internet Content-Entmnt
Internet Content-Info/Ne
Internet Gambling
Internet Incubators
Internet Infrastr Equip
Internet Infrastr Sftwr
Internet Security
Internet Telephony
Intimate Apparel
Invest Comp - Resources
Invest Mgmnt/Advis Serv
Investment Companies
Lasers-Syst/Components
Leisure&Rec Products
Leisure&Rec/Games
Life/Health Insurance
Lighting Products&Sys
Linen Supply&Rel Items
Lottery Services
Mach Tools&Rel Products
Machinery-Constr&Mining
Machinery-Electric Util
Machinery-Electrical
Machinery-Farm
Machinery-General Indust
Machinery-Material Handl
Machinery-Print Trade
Machinery-Pumps
Machinery-Therml Process

1.51
3.96
1.10
1.16
0.87
0.72
1.15
0.84
1.53
1.48
1.60
1.34
1.18
1.09
1.23
1.36
1.28
1.39
0.95
1.05
1.42
1.35
1.09
1.67
0.79
1.05
3.56
1.28
0.70
1.27
1.60
0.87
1.87
1.18
1.41
1.52
1.27
3.29
1.19
1.69
NA
1.67
1.41
1.36
1.39
1.16
1.61
1.37
1.60
1.42
1.13
1.55

Marine Services
Medical Imaging Systems
Medical Information Sys
Medical Instruments
Medical Labs&Testing Srv
Medical Laser Systems
Medical Products
Medical Steriliz Product
Medical-Biomedical/Gene
Medical-Drugs
Medical-Generic Drugs
Medical-HMO
Medical-Hospitals
Medical-Outptnt/Home Med
Medical-Whsle Drug Dist
Metal Processors&Fabrica
Metal Products-Distrib
Metal Products-Fasteners
Metal-Aluminum
Metal-Copper
Metal-Diversified
Metal-Iron
Mining Services
Miscellaneous Manufactur
Money Center Banks
Mortgage Banks
Motion Pictures&Services
Motorcycle/Motor Scooter
Multi-line Insurance
Multilevel Dir Selling
Multimedia
Music
Networking Products
Non-Ferrous Metals
Non-hazardous Waste Disp
Not classified
Office Automation&Equip
Office Furnishings-Orig
Office Supplies&Forms
Oil Comp-Explor&Prodtn
Oil Comp-Integrated
Oil Field Mach&Equip
Oil Refining&Marketing
Oil-Field Services
Oil&Gas Drilling
Optical Supplies
Paper&Related Products
Pastoral&Agricultural
Patient Monitoring Equip
Petrochemicals
Pharmacy Services
Photo Equipment&Supplies

1.65
1.31
1.00
1.59
1.04
NA
1.41
1.32
1.10
1.13
1.11
NA
0.87
0.93
1.18
1.53
1.50
1.07
1.50
1.18
1.53
1.25
1.21
1.21
0.72
1.57
1.27
1.23
1.17
0.68
1.16
1.04
1.60
1.90
1.39
0.91
1.56
0.92
1.73
1.59
1.46
2.18
1.31
1.71
1.68
0.73
1.16
1.20
1.39
1.33
NA
1.56

Phys Practice Mgmnt

Pipelines
Platinum
Pollution Control
Poultry
Power Conv/Supply Equip
Precious Metals
Printing-Commercial
Professional Sports
Property Trust
Property/Casualty Ins
Protection-Safety
Public Thoroughfares
Publishing-Books
Publishing-Newspapers
Publishing-Periodicals
Quarrying
Racetracks
Radio
Real Estate Mgmnt/Servic
Real Estate Oper/Develop
Recreational Centers
Recycling
Regional Banks-Non US
Reinsurance
Remediation Services
Rental Auto/Equipment
Research&Development
Resorts/Theme Parks
Respiratory Products
Retail-Apparel/Shoe
Retail-Appliances
Retail-Auto Parts
Retail-Automobile
Retail-Bookstore
Retail-Building Products
Retail-Catalog Shopping
Retail-Computer Equip
Retail-Consumer Electron
Retail-Convenience Store
Retail-Discount
Retail-Drug Store
Retail-Hair Salons
Retail-Home Furnishings
Retail-Hypermarkets
Retail-Jewelry
Retail-Major Dept Store
Retail-Misc/Diversified
Retail-Office Supplies
Retail-Perfume&Cosmetics
Retail-Petroleum Prod
Retail-Regnl Dept Store

1.30
1.42
1.75
1.18
1.06
1.47
1.52
1.16
0.46
0.45
1.29
0.78
1.28
0.76
1.05
0.91
1.02
0.38
0.76
1.30
1.56
1.00
1.32
1.15
0.96
0.78
1.29
2.55
1.09
0.63
1.20
1.15
0.36
1.17
NA
1.09
2.28
1.26
1.06
0.93
0.81
1.28
0.87
1.16
0.81
1.17
1.43
1.29
1.04
1.03
1.15
1.21

Retail-Restaurants
Retail-Sporting Goods
Retail-Toy Store
Rubber-Tires
Rubber/Plastic Products
Rubber&Vinyl
Satellite Telecom
Schools
Security Services
Seismic Data Collection
Semicon Compo-Intg Circu
Semiconductor Equipment
Shipbuilding
Silver Mining
Soap&Cleaning Prepar
Special Purpose Banks
Special Purpose Entity
Specified Purpose Acquis
Steel Pipe&Tube
Steel-Producers
Steel-Specialty
Stevedoring
Storage/Warehousing
Sugar
Superconductor Prod&Sys
Tannery
Tea
Telecom Eq Fiber Optics
Telecom Services
Telecommunication Equip
Telephone-Integrated
Television
Textile-Apparel
Textile-Home Furnishings
Textile-Products
Theaters
Therapeutics
Tobacco
Tools-Hand Held
Toys
Transactional Software
Transport-Air Freight
Transport-Equip&Leasng
Transport-Marine
Transport-Rail
Transport-Services
Transport-Truck
Travel Services
Venture Capital
Veterinary Diagnostics
Veterinary Products
Vitamins&Nutrition Prod

1.00
NA
1.59
1.30
1.21
1.29
1.07
1.13
1.63
1.05
1.71
1.33
1.82
1.05
1.07
0.78
0.68
0.34
1.39
1.53
1.48
1.13
1.29
1.25
1.54
0.91
1.29
1.29
1.26
1.38
1.03
1.24
1.19
0.67
1.24
1.32
1.17
0.86
1.36
1.10
1.37
0.95
0.79
1.54
0.97
1.24
1.41
1.09
1.36
1.39
1.42
1.59

Water
Water Treatment Systems
Web Hosting/Design
Web Portals/ISP
Whsing&Harbor Trans Serv
Wire&Cable Products
Wireless Equipment
Wool
Wound,Burn&Skin Care
X-Ray Equipment

1.11
1.41
1.46
1.52
0.95
1.44
1.54
NA
1.64
1.49

Data

From Aswath Damodaran's web site, damodaran.com

Data Sets
Historical Returns on Stocks, Bonds and Bills United States

Download
Excel file
Download

Archived Data

Implied Equity Risk Premiums - United States

Download

Risk Premiums for Other Markets

Download 2000, 2001, 2002, 2003,

2004, 2005 , 2006

Levered and Unlevered Betas by Industry

U.S.

Marginal tax rate by country

Download

Total Beta By Industry Sector

Download 1998, 1999, 2000, 2001,

2002, 2003, 2004 , 2005 ,
2006

Risk Measures by Market Cap Class

Download

Costs of Capital by Industry Sector

Download 1998, 1999, 2000, 2001,

2002, 2003 , 2004 , 2005 ,
2006

1998, 1999, 2000, 2001,

2002, 2003. 2004 , 2005 ,
2006

Description
This data set includes actual returns on stocks, bonds and bills for the United States from
1928 to the most recent year. It is a useful starting point for estimating historical equity
premiums.
These risk premiums are estimated based upon a simple 2-stage Dividend discount model
and reflect the risk premium which would justify they current level of the index, given the
dividend yield, expected growth in earnings and the level of the long term bond rate.
These are risk premiums estimates for other markets based upon the country ratings
assigned by Standard and Poors'.
This data set lists betas by industrial sector. The betas are computed using 5 years of
monthly returns for each stock and then averaged (simple). The unlevered betas are
estimated using the average market debt/equity ratios by industrial sector. (Hamada betas).
This is the KPMG survey of corporate tax rates by country. Please give them full credit
when you use any of the information from this file.
These are betas adjusted to reflect a firm's total exposure to risk rather than just the market
risk component. It is a function of the market beta and the portion of the total risk that is
market risk. These betas might provide better estimates of costs of equity for undiversified
owners of businesses.
These are risk measures - standard deviatiions, betas, total betas and hilo risk - broken
down for U.S. firms into ten market cap classes. Make of it what you will.
This data set lists costs of equity, costs of debt, market debt ratios and costs of capital by
industrial sector.