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When you COMBINE BOTH the interest rate of debt AND the ‘expected return’ of the investors/owners, we get the total cost of capital.
If the cost of debt (e.g. interest) and cost of equity (expected return) are different, then we have to get an AVERAGE of the two to get our COST OF CAPITAL
Cost of capital is expressed as a percentage; because it’s compared to the total capital (as a percentage of the total capital). Just like bank loan interest is expressed as a percentage of your total loan.
What if your company has more debt vs. equity, OR vice versa? Then our formula must give more importance or ‘WEIGHT’ to whichever is bigger; and must give LESS weight to whichever is SMALLER. Thus, we have the WACC or Weighted Average Cost of Capital concept.
This is the basic WACC or Weighted Average Cost of Capital Formula:
WACC = (Debt Proportion)(Cost of Debt %)(1 – tax rate %) + (Equity Proportion)(Cost of Equity %)
To understand this formula step-by-step in action, watch my free video below.
Step-by-step WACC CalculationPart 1
Step-by-step WACC CalculationPart 2
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WACC Weighted Average Cost of Capital in 3 Minutes, 4.6 out of 5 based on 28 ratings