What is the Weighted Average Cost of Equity (WACE)?
Let me explain what the Weighted Average Cost of Equity, or WACE, really is. It's a method to figure out the cost of a company's equity by giving different weights to various types of equities based on their share in the company's structure. You shouldn't just lump together retained earnings, common stock, and preferred stock; WACE gives you a clearer picture of the total equity cost.
Getting an accurate cost of equity is crucial for any firm when calculating its overall cost of capital. And you need that precise cost of capital to decide if a future project will actually make money or not.
How the Weighted Average Cost of Equity (WACE) Works
The WACE is basically like the cost of equity from the Capital Asset Pricing Model (CAPM), but with weights applied to reflect the current mix of equity types in your company. If you just average the costs without weighting, any outliers could skew the result, either overstating or understating the true cost.
Key Takeaways
- The weighted average cost of equity (WACE) measures the cost of equity proportionally for a company rather than simply averaging the overall figures.
- With the weighted average cost of equity, the cost of a particular equity type is multiplied by the percentage of the capital structure it represents.
- The cost of equity used in most formulas is usually a weighted average cost of equity, even if this is not explicitly stated.
Calculating the Weighted Average Cost of Equity (WACE)
Calculating WACE isn't as simple as figuring out the cost of debt. First, you have to determine the cost of new common stock, preferred stock, and retained earnings separately. The standard way is using the CAPM formula: Cost of equity = Risk-free rate of return + [beta x (market rate of return – risk-free rate of return)].
Typically, these costs for common stock, preferred stock, and retained earnings stay in a narrow range. For this example, assume they're 14%, 12%, and 11% respectively.
Next, figure out what portion of total equity each type takes up—say 50% for common stock, 25% for preferred stock, and 25% for retained earnings.
Then, multiply each cost by its portion and add them up to get the WACE. In our case, that's (.14 x .50) + (.12 x .25) + (.11 x .25) = 0.1275 or 12.8%.
If you just averaged them, you'd get 12.3%, but that's not common practice. WACE is usually part of the bigger Weighted Average Cost of Capital (WACC) calculation.
Why the Weighted Average Cost of Equity (WACE) Matters
If you're a potential buyer looking at acquiring a company, you might use WACE to value future cash flows. Combine it with things like after-tax cost of debt for a full assessment. More often, WACE pairs with the weighted average cost of debt to form the WACC.
Within the company, as part of WACC, WACE helps evaluate how campaigns and big projects affect shareholder returns. On its own, WACE can discourage issuing new stock for raising capital, since debt like bonds is usually cheaper and easier for investors to analyze on the balance sheet.
