What is the Weighted Average Cost of Equity (WACE)?
Weighted Average Cost of Equity (WACE) provides an enhanced method to calculate a company’s cost of equity by assigning different weights to various types of equity based on their proportion in the corporate structure. This approach delivers a more precise estimation of the company’s total cost of equity by considering retained earnings, common stock, and preferred stock individually.
Understanding the accurate cost of equity is crucial for firms to estimate their cost of capital and to decide if future projects will be profitable.
How the Weighted Average Cost of Equity (WACE) Works
The WACE mirrors the Capital Asset Pricing Model (CAPM), but with weights reflecting the company’s equity mix. Simple averaging could distort the estimation due to the presence of outliers.
Key Takeaways:
- WACE assesses the cost of equity proportionally rather than averaging overall figures.
- It multiplies the cost of a specific equity type by the percentage that type represents in the capital structure.
- Most cost of equity formulas implicitly use WACE.
Calculating the Weighted Average Cost of Equity (WACE)
Calculating WACE involves determining the cost of new common stock, preferred stock, and retained earnings separately. Using the CAPM formula:
Cost of equity = Risk-free rate of return + [beta x (market rate of return - risk-free rate of return)]
Assume the costs are 14%, 12%, and 11% for common stock, preferred stock, and retained earnings, respectively. If these forms occupy 50%, 25%, and 25% of the total equity:
WACE = (0.14 x 0.50) + (0.12 x 0.25) + (0.11 x 0.25) = 12.8%
Simple averaging would yield 12.3%, showing the significance of the weighted approach, particularly when calculating the company’s Weighted Average Cost of Capital (WACC).
Why the Weighted Average Cost of Equity (WACE) Matters
Potential buyers can use WACE to value future cash flows of a target company, often combined with other metrics like the after-tax cost of debt. Within a company, WACE ensures accurate return on earnings for shareholders, potentially guiding decisions on issuing new stock or raising capital through bonds. Debt generally offers a cheaper capital-raising method, and its costs can be more straightforward for balance sheet analysis.
Related Terms: Cost of Equity, Weighted Average Cost of Capital (WACC), Capital Asset Pricing Model (CAPM), Risk-free Rate, Beta, Market Rate of Return.
