What it means
A company's equity is rarely one uniform block. It can include founders' common shares, newer shares sold to investors, preferred shares with fixed dividends, and profits that were kept in the business rather than paid out.
Each layer carries a different required return. Preferred shares usually demand less because they rank ahead of common shares, while newly issued common shares often demand the most because they carry the greatest risk and also involve issue costs.
WACE blends those required returns by weighting each by the value of that layer. The result is a single equity rate that can then be combined with the cost of debt to produce the overall weighted average cost of capital.
Finance teams use it when one equity rate would misrepresent the picture. A company that has raised several funding rounds on different terms, for example, can show owners and lenders how much its equity really costs on average.
The abbreviation is not universal, so reports should spell out the full phrase on first use. The inputs are also estimates, because the required return on equity cannot be read from a contract the way an interest rate can.
The figure should match the funding actually used for a decision. A project paid for entirely from retained profits is better judged against the retained earnings rate, while a company-wide valuation is better judged against the blend.
Using the wrong one can flip the answer on a marginal project.
In practice
Real-world examples.
Example
A growth-stage technology company has raised money in three rounds at different valuations and terms. Its finance lead calculates WACE to show the board the average return its investors expect across all rounds, which feeds into the discount rate for a planned acquisition. She also shows how the figure changes if the next round is priced higher or lower.
Example
A family-owned manufacturer keeps most profits in the business and has a small block of preferred shares held by a bank. The owners calculate WACE to see whether retaining profits is really cheaper than issuing new shares to outside investors. They find it is cheaper, but not free, because the family still expects a return on money left in the business.
Example
A regulated utility reports its equity cost to a pricing regulator. Because part of its equity is preferred stock at a fixed dividend, the blended WACE is lower than the required return on common shares alone. The regulator asks the utility to explain each input, so the finance team keeps a short schedule listing every layer and its source.
Formula
Calculation
WACE = sum of (value of each equity layer / total equity x required return on that layer)
Suppose a company has $5,000,000 of new common shares with a required return of 13%, $3,000,000 of retained earnings at 11% and $2,000,000 of preferred shares at 8%, so total equity is $10,000,000. The weights are 50%, 30% and 20%. WACE = (0.5 x 13%) + (0.3 x 11%) + (0.2 x 8%) = 6.5% + 3.3% + 1.6% = 11.4%. The blended equity cost of 11.4% sits between the cheapest and dearest layers. If the preferred shares were repaid, the remaining $8,000,000 would be weighted 62.5% at 13% and 37.5% at 11%, so WACE = 8.125% + 4.125% = 12.25%, which shows how removing a cheap layer pushes the blend up.Case study
Seen in the real world.
Northgate Bakeries is an illustrative, fictional food producer funded by $8,000,000 of common shares at a required return of 12% and $2,000,000 of preferred shares paying 7%. The managers had been using 12% as the equity rate in every investment appraisal.
The finance director pointed out that the owners as a group were not expecting 12% on every dollar. Weighting the layers gave (0.8 x 12%) + (0.2 x 7%) = 9.6% + 1.4% = 11.0%.
Using the lower blended figure moved two borderline projects over the hurdle, but the illustrative lesson was also cautionary. Adding the preferred layer lowered the average without making common shareholders any less demanding, so the board kept 12% for projects that would be funded purely by common equity. Northgate now records both figures in its capital budgeting manual, with a note on which one applies to which type of project.
Watch out
Common mistakes.
- Using the cheapest layer of equity as the cost for all equity, which understates what the owners as a whole expect.
- Weighting by book value when the market values of the layers are known and quite different.
- Confusing WACE with WACC, when WACE covers only the equity side and ignores debt.
Questions
People also ask.
How does WACE relate to WACC?
WACE supplies the equity half of WACC, which then adds the after-tax cost of debt in proportion to its share of funding.
Why would a company need a blended equity rate?
Different groups of shareholders accept different returns, so a single blended figure shows the average expectation across all of them.
Can WACE be higher than the cost of debt?
Almost always, because equity holders carry more risk than lenders and expect a higher return. Preferred shares can come close to debt in cost, but they still rank behind lenders.
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