What It Measures
The weighted average cost of capital (WACC) is the rate of return that the providers of a company’s capital require, weighted according to the proportion each element bears to the total pool of capital.
Why It Is Important
WACC is one of the most important figures in assessing a company’s financial health, both for internal use (in capital budgeting) and external use (valuing companies on investment markets). It gives companies an insight into the cost of their financing, can be used as a hurdle rate for investment decisions, and acts as a measure to be minimized to find the best possible capital structure for the company. WACC is a rough guide to the rate of interest per monetary unit of capital. As such, it can be used to provide a discount rate for cash flows with similar risk to that of the overall business.
How It Works in Practice
To calculate the weighted average cost of capital, companies must multiply the cost of each element of capital for a project—which may include loans, bonds, equity, and preferred stock—by its percentage of the total capital, and then add them together.
For example, a business might consider investing $40 million in an expansion program. The financing is raised through a combination of equity (such as $10m of stock with an expected 10% return) and debt (for example, $30m bond issue, with 5% coupon).
In this simple scenario, WACC would be calculated as follows:
Equity ($10m) divided by total capital ($40m) = 25%, multiplied by cost of equity (10%) = 2.5%
Debt ($30m) divided by total capital ($40m) = 75%, multiplied by cost of debt (5%) = 3.75%
The two results added together give a weighted cost of capital of 6.25%.
In reality, interest payments are tax deductible, so a more accurate formula for WACC is:
WACC = DP × DC − T + EP × EC
Tricks of the Trade
To accurately calculate WACC, you need to know the specific rates of return required for each source of capital. For example, different sources of finance may attract different levels of taxation, or interest, which should be accounted for. A true WACC calculation could therefore be much more complex than the example provided here.
Critics of WACC argue that financial analysts rely on it too heavily, and that the algorithm should not be used to assess risky projects, where the cost of capital will necessarily be higher to reflect the higher risk.
Investors use WACC to help decide whether a company represents a good investment opportunity. To some extent, WACC represents the rate at which a company produces value for investors—if a company produces a return of 20% and has a WACC of 11%, then the company creates 9% additional value for investors. If the return is lower than the WACC, the business is unlikely to secure investment.
Although the WACC formula seems simple, different analysts will often come up with different WACC calculations for the same company depending on how they interpret the company’s debt, market value, and interest rates.