Weighted Average Cost of Equity - Explained
What is the Weighted Average Cost of Equity?
Written by Jason Gordon
Updated at October 11th, 2021
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Table of Contents
What is the Weighted Average Cost of Equity?How Does the Weighted Average Cost of Equity Work?Why the Weighted Average Cost of Equity MattersWhat is the Weighted Average Cost of Equity?
In finance and accounting, cost of equity in a company is determined using the weighted average cost of equity (WACE). Weighted average cost of equity (WACE) calculates the cost of equity in a company by allocated different weights to different aspects of the company's equity. Knowing the accurate cost of a company's equity is important in determining the cost of capital of the company as well as the amount of compensation to be paid to investors. Also, when the cost of capital is determined, it is easy to make important decisions as to whether a company should take on a project or otherwise.
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How Does the Weighted Average Cost of Equity Work?
To calculate the weighted average cost of equity of a firm, here are the steps to follow;
- Estimate the costs of new common stock, preferred stock am retained earnings of the firm.
- Estimate the value of equity that each from of equity (new common stock, preferred stock am retained earnings) occupies.
- Multiply each cost of equity by its proportion in the overall equity. This result gives us the WACE.
Why the Weighted Average Cost of Equity Matters
Investors consider the weighted average cost of equity to check how profitable an investment would be. In an acquisition, acquiring companies also check the WACE of the target company and use the value in assessing the future performance of the firm and future cash flows. Analysts also assess a firm using its weighted average cost of equity. This is with the aim of detecting deficiencies in the company's approaches, if there are any and to introduce new methodologies.