How to calculate cost of debt: wacc

Written by james collins | 13/05/2017
How to calculate cost of debt: wacc
Use the balance sheet to help calculate the WACC for debt. (Jupiterimages/Comstock/Getty Images)

There are two basic ways for investors to invest in a company -- through stocks and bonds. While stocks represent ownership, bonds represent a debt to the company. In addition to bonds, a company may also acquire bank debt in order to maintain operations. One measure corporate analysts use when assessing whether or not to accept a project proposal is the cost of both equity and debt capital. If a company has more than one form of debt, there may be multiple interest rates associated with the cost of debt. In this case, the analyst will take the weighted average cost of debt capital (WACC).

Obtain the annual report. You can obtain the annual report by contacting the company, or you may be able to download the annual report directly from the website.

Turn to the balance sheet. The balance sheet is a snapshot of company assets and liabilities including long-term debt. Assume the amount of total long-term debt is £65,000.

Turn to the notes for the balance sheet immediately following the financial statements. Within the notes, turn to the section titled Long-term Debt. There will be a chart or a description of each loan and how much the company is paying in interest on each loan. Assume the company has three loans for £65,000, £130,000, and £195,000, and each loan is paying 10 per cent, 7 per cent, and 3 per cent, respectively.

Calculate the weights for each loan. There are a total of £390,000 in loans to the company and the weight is calculated by dividing the amount of the loan by the amount of total loans. In this example, the weights are £65,000 divided by £390,000 or 1/6, £130,000 divided by £390,000 or 2/6, and £195,000 divided by £390,000 or 3/6.

Multiply the weights by the interest rate associated with the loan. For instance, the £65,000 loan was made for 10 per cent, but only represents 1/6 of the total long-term debt. 1/6 multiplied by 10 per cent is 1.67 per cent. Perform the same calculation for the second and third loan. 2/6 multiplied by 7 per cent is 2.3 per cent, and 3/6 multiplied by 3 per cent is 1.5 per cent.

Calculate the cost of debt WACC. Sum the weighted interest rates for the total weighted average. The calculation is 1.67 plus 2.33 plus 1.50 equals 5.50 per cent.

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