Weighted Average Cost of Equity (WACE)

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Weighted Average Cost of Equity (WACE)

Weighted Average Cost of Equity (WACE) measures a company’s overall cost of equity by combining the costs of its different equity components—commonly retained earnings, common stock, and preferred stock—weighted by their share of the firm’s equity capital. Using weights produces a more accurate cost-of-equity estimate than a simple average, because it reflects the firm’s actual capital structure.

Why WACE matters

  • It provides a realistic cost of equity to use in investment appraisal and valuation.
  • It is a key input to a firm’s weighted average cost of capital (WACC), which investors and managers use to assess project viability and value future cash flows.
  • It helps guide financing decisions: issuing new equity raises capital but may increase the firm’s overall cost of capital relative to cheaper debt financing.

How WACE is calculated

  1. Estimate the cost of each equity component:
  2. Cost of common equity — typically estimated with the Capital Asset Pricing Model (CAPM):
    Cost of equity = Risk-free rate + beta × (Market return − Risk-free rate)
  3. Cost of preferred stock — often estimated as the preferred dividend divided by the net issuing price (Dividend / Price).
  4. Cost of retained earnings — usually proxied by the cost of common equity, though adjustments may be made for flotation or opportunity costs.
  5. Determine each component’s weight as a percentage of total equity.
  6. Compute WACE as the weighted sum:
    WACE = Σ (weight_i × cost_i)

Example

Assume:
* Cost of common equity = 14% (weight = 50%)
* Cost of preferred stock = 12% (weight = 25%)
* Cost of retained earnings = 11% (weight = 25%)

WACE = (0.14 × 0.50) + (0.12 × 0.25) + (0.11 × 0.25)
WACE = 0.07 + 0.03 + 0.0275 = 0.1275 → 12.75% (≈ 12.8%)

A simple (unweighted) average of the three rates would be 12.33%, which understates or misrepresents cost when the components aren’t equally sized.

Practical considerations and limitations

  • Inputs are estimates: beta, expected market return, and risk-free rate are subject to judgment and market conditions.
  • CAPM assumptions (e.g., markets are efficient, single-period horizon) may not hold for all firms or situations.
  • Costs can differ between new equity and retained earnings due to flotation costs or signaling effects—use appropriate adjustments when relevant.
  • Capital structure changes over time; weights should reflect the target or current capital structure consistent with the valuation or decision context.

Key takeaways

  • WACE gives a proportionally weighted measure of the firm’s cost of equity rather than a simple average.
  • It is calculated by multiplying each equity component’s cost by its share of total equity and summing the results.
  • WACE is commonly used in WACC and valuation, and its accuracy depends on the quality of underlying estimates and the chosen capital-structure weights.