Weighted average cost of capital is the cost to a business of raising capital. This capital can take the form of equity (common or preferred shares) or debt, or some combination of debt and equity. The cost of debt is generally determined to be the interest rate which would be charged to the business if it were to borrow long-term debt and can often be estimated based upon the company’s existing credit facilities. The cost of equity is somewhat more difficult to determine for a private company as it reflects the rate of return that an equity investor would require in order to acquire shares of the company. The cost of equity is usually estimated by the valuator based on a comparison of the operations and financial characteristics of the company to other private companies or a number of comparable public companies for which the cost of equity is readily determinable.
The weighted average cost of capital is then determined by weighting the cost of debt and cost of equity relative to the optimal capital structure for the business (debt capital vs. equity capital). Since interest expense is deductible for tax purposes, the cost of debt is calculated net of the tax savings generated on the deductible interest expense.
Weighted average cost of capital can then be used to determine the net present value of a series of expected future cash flows of a business. The sum of the net present values of the future cash flows discounted at the weighted average cost of capital is the company’s enterprise value. The company’s equity value can then be determined by deducting the value of the company’s outstanding debt from the enterprise value.