Key Takeaways
- Blended cost of multiple equity sources.
- Used for evaluating equity-financed projects.
- Excludes debt costs unlike WACC.
What is Weighted Average Cost of Equity (WACE)?
Weighted Average Cost of Equity (WACE) is the blended cost of multiple equity financing sources, such as common stock, preferred stock, and retained earnings, weighted by their respective proportions in the total equity structure. It reflects the overall return a company must generate on its equity to satisfy various equity investors, distinct from the Weighted Average Cost of Capital (WACC), which includes debt costs.
WACE is critical for companies with diverse equity components, including many C corporations, guiding decisions on equity-financed projects and valuation.
Key Characteristics
WACE has several defining features that distinguish it from related concepts.
- Equity-focused: Unlike WACC, WACE considers only equity financing, excluding debt and tax effects.
- Weighted average: It combines costs from common stock, preferred stock, and retained earnings based on their market value proportions.
- Reflects investor expectations: Each equity source’s required return captures different risk profiles and investor demands.
- Calculation inputs: Uses models like CAPM for common stock cost and dividend yields for preferred stock.
- Applicable to complex equity structures: Especially relevant for firms issuing preferred shares or multiple classes of stock, such as A shares.
How It Works
To calculate WACE, first identify each equity source's individual cost—for example, the cost of common stock via CAPM, which factors in the risk-free rate, beta, and equity risk premium. Then, determine each source's proportion of total equity.
The formula weights each cost by its equity share: WACE = (proportion of common stock × cost of common stock) + (proportion of preferred stock × cost of preferred stock) + (proportion of retained earnings × cost of retained earnings). This approach ensures you capture the blended return required across all equity holders.
Examples and Use Cases
WACE is especially useful for companies with varied equity financing, providing a comprehensive cost measure for capital budgeting and valuation.
- Financial sector: Banks like Bank of America and JPMorgan Chase often calculate WACE to evaluate equity project returns amid multiple equity classes.
- Consumer finance: Wells Fargo incorporates WACE when assessing returns on equity-funded initiatives.
- Corporate finance: Firms like Citigroup use WACE to balance costs between common and preferred stockholders effectively.
Important Considerations
When applying WACE, keep in mind that it assumes a relatively stable equity mix; significant changes in capital structure can alter the weighted average cost. Also, estimating components like beta for private firms can be challenging and may require adjustments based on comparable public companies.
WACE is most valuable for companies with multiple equity classes. If your firm has a simple equity structure, using a single cost of equity may suffice. Understanding how WACE differs from related metrics will help you apply it correctly in financial analysis and decision-making.
Final Words
The weighted average cost of equity (WACE) gives you a clear picture of the overall return your equity investors expect based on the mix of equity sources. To apply this insight, calculate your company’s WACE regularly and compare it against your project returns to ensure value creation.
Frequently Asked Questions
Weighted Average Cost of Equity (WACE) is the average cost of multiple sources of equity financing, such as common stock, preferred stock, and retained earnings, weighted by their proportion in the total equity structure. It represents the minimum return a company must generate on its equity to satisfy all equity investors.
WACE focuses solely on the cost of equity components and excludes debt, while WACC blends both equity and debt costs, adjusting debt for taxes. This makes WACE typically higher than WACC since it does not include cheaper, tax-deductible debt financing.
WACE helps companies with multiple equity types, like common stock, preferred stock, and retained earnings, assess the blended cost of these financing sources. This is crucial for capital budgeting and valuation, ensuring projects meet the overall required return on equity.
First, determine the cost of each equity source, often using methods like CAPM for common stock. Then, find each source's proportion in total equity and multiply each cost by its weight. Summing these weighted costs gives the WACE.
Yes, for private firms, WACE can be estimated by using beta values from comparable public companies and adding company-specific risk premiums. The equity base is typically the net worth, calculated as total assets minus liabilities.
WACE = (E_common / E_total × Re_common) + (E_preferred / E_total × Re_preferred) + (E_retained / E_total × Re_retained), where E represents the market value of each equity source and Re is its cost.
WACE sets the minimum return threshold that equity-financed projects must achieve to satisfy investors. It guides capital budgeting by ensuring projects generate returns that cover the blended cost of all equity sources.
