Weighted average cost of capital: A measure of the rate companies pay to finance their operations
- Weighted average cost of capital (WACC) is a key metric that shows a company's cost of capital across its debt and equity.
- If a company's WACC is elevated, the cost of financing for the company is higher, which is usually an indication of greater risk.
- Investors often use WACC to determine whether a company is worth investing in or lending money to.
The weighted average cost of capital (WACC) is a financial ratio that measures a company's financing costs. It weighs equity and debt proportionally to their percentage of the total capital structure. A company's executives use WACC in making decisions about how to fund operations or projects, and it helps investors determine the minimum rate of return they're willing to accept on their money.
Companies raise capital from external sources in two main ways: by selling stock or taking on debt in the form of bonds or loans. Understanding the cost of that financing is a crucial part of the decision-making process for managers running the business and a key metric for investors in choosing whether to invest. If a company has just one type of capital, equity or debt, figuring out the cost is relatively straightforward. WACC is a more complicated measure of the average rate of return required by all of its creditors and investors.
What is WACC used for?
WACC determines the rate a company is expected to pay to raise capital from all sources. This includes bonds and other long-term debt, as well as both common and preferred shares of stock. It gives management a view of its overall cost of borrowing and helps determine how much of a return on new projects or operations will be required to justify the cost of financing them.
Investors use WACC to decide if the company is worth investing in or lending money to. If the WACC is elevated, the cost of financing for the company is higher, which is usually an indication of greater risk. Conversely, a lower WACC signals relatively low financing cost and less risk.
"The formula uses the cost of each of the sources of capital and weighs them relevant to the market value of the business," says Daniel Milan, an investment advisor at Cornerstone Financial Services. "This is important because it gives an analyst an idea of how much interest a company has to pay for each dollar that it finances for its operations or assets. This is critical in the evaluation of the value of an investment."
How is WACC calculated?
There are a couple of ways to calculate WACC, which is expressed as a percentage. Here's the basic formula:
In essence, you first establish the cost of debt and the cost of equity. Then you multiply each of those by their proportionate weight of market value. Add those two figures together and multiply the result by the business's corporate tax rate.
A more complicated formula can be applied in the event that the company has preferred shares of stock, which are valued differently than common shares because they typically pay out fixed dividends on a regular schedule.
Note: A high WACC indicates that a company is spending a relatively large amount of money to raise capital.
An example of how to use WACC
Determining the cost of equity and the cost of debt can be quite a complicated process, depending on the company's capital structure. But once you have all the data, calculating the WACC is relatively straightforward.
Let's say a company has $3 million of market value in equity and $2 million in debt, making its total capitalization $5 million. Its tax rate is 21%, its cost of equity is 9%, and its cost of debt is 6%.
- E = $3,000,000
- D = $2,000,000
- Tc = 21%
- Re = 9%
- Rd = 6%
- V = $5,000,000
Calculating the weighted cost of capital is then just a matter of plugging those numbers into the formula:
- WACC = (E÷V x Re) + (D÷V x Rd x (1-Tc))
- WACC = ($3,000,000/$5,000,000 x 0.09) + ($2,000,000/$5,000,000 x 0.06 x (1-0.21))
- WACC = (0.054) + (0.019) = 0.073
- WACC = 7.3%
While it helps to know the formula to get a better understanding of how WACC works, it's rarely calculated manually. There are many interactive calculators and Excel templates available that can do the math for you.
The financial takeaway
While WACC isn't one of the most commonly used metrics by individual investors like, say, a company's price-to-earnings ratio, professionals regularly use it as part of their in-depth analysis of various investment opportunities. And it's something you're likely to see in analyst reports you come across when researching stocks.
"Weighted average cost of capital is a formula that can be used to gain an insight into how much interest a company owes for each dollar it finances," says Maxim Manturov, head of investment research at Freedom Holding Corp. "For this reason, the approach is popular among analysts looking to assess the true value of an investment."
However you get it — either on your own or from a research report on a company you're interested in — WACC shows a firm's blended cost of capital from all sources of financing. It represents the average rate of return it needs to earn to satisfy all of its investors. That's one factor to consider when weighing whether the potential returns are worth the risk you're taking by investing.
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