The weighted average cost of capital (WACC) is a financial metric that represents a companys blended cost of capital across all sources, including common shares, preferred shares, and debt. It is the average rate that a company is expected to pay on average to all its security holders to finance its assets. WACC is calculated by proportionately weighing the cost of each capital source (debt and equity) by its relevant weight by market value, then adding the products together to determine the total. The formula for WACC is:
WACC = (VE x Re) + (VD x Rd x (1 - Tc))
where:
- VE = Market value of the firms equity
- VD = Market value of the firms debt
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
The WACC is an important concept to understand for finance professionals, especially for investment banking, equity research, and corporate development roles. It is used as a hurdle rate by companies and investors to gauge the desirability of a given project or acquisition. The WACC serves as the discount rate for calculating the value of a business and is considered to represent the firms opportunity cost of capital.
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM), which equates rates of return to volatility (risk vs reward) . The cost of debt is the interest rate a company pays on its debt. The market values of debt and equity should be used when computing the weights in the WACC formula. Tax effects should also be considered when calculating WACC.
WACC is used widely throughout the finance industry, but it is not without its faults. One major issue with using WACC is that it assumes that the companys capital structure will remain constant, which may not be the case in reality.
