Weighted Average Cost of Capital (WACC)

What is the Weighted Average Cost of Capital (WACC)?

Weighted average cost of capital – commonly abbreviated as WACC – is a financial metric used by companies to determine the expected cost to finance their business through equity or debt.

Key Takeaways

The weighted average cost of capital (WACC) helps companies determine the cost of getting money for financing new projects or businesses.
WACC combines the cost of debt and equity proportionally.
A lower WACC means it’s cheaper to finance operations, while a higher WACC means it’s more expensive.
WACC factors tax benefits on debt and is sensitive to interest rate changes.
WACC relies on assumptions and estimates, which may affect the accuracy of its calculation.
WACC Components

Table of Contents Table of Contents

What is the Weighted Average Cost of Capital (WACC)?
Key Takeaways
WACC Components
WACC Formula and Calculation
WACC Calculation Example
5 Variables That Affect WACC
WACC vs. Required Rate of Return (RRR)
WACC in Different Industries
WACC Limitations
The Bottom Line
FAQs

Table of Contents

What is the Weighted Average Cost of Capital (WACC)?
Key Takeaways
WACC Components

Show Full Guide

WACC Formula and Calculation
WACC Calculation Example
5 Variables That Affect WACC
WACC vs. Required Rate of Return (RRR)
WACC in Different Industries
WACC Limitations
The Bottom Line
FAQs

WACC Components

There are several factors that play a role in the calculation of WACC.

These include:

Cost of equity

The return on investment (ROI) for equity investors.

Cost of debt

The rate a company pays to borrow capital in the form of bonds or other debt.

Cost of preferred stock (if applicable)

The cost of issuing preferred shares, which offer a fixed dividend to investors.

Equity weight

The proportion of the company’s capital that comes from equity.

Debt weight

The proportion of the company’s capital that comes from debt.

Preferred stock weight (if applicable)

The proportion of the company’s capital that comes from preferred stock.

WACC Formula and Calculation

E = equity value of the company

D = debt value of the company

V = E+D

Re = cost of equity

Rd = cost of debt

Tc = corporate tax rate

WACC Calculation Example

Imagine you’re a retail company that is looking to open 50 new stores across the country, which are expected to generate a 9% return on investment. Your company currently has 40% of its financing from debt and 60% from its equity shareholders, with a corporate tax rate of 20%.

For their investment, shareholders expect a 10% return on their investment, while your debt is in the form of a bank loan at 5% interest.

You have all the information you need to determine your WACC and whether opening 50 new stores is financially viable.

Re = 10% (Cost of Equity)
Rd = 5% (Cost of Debt)
E/V = 60% (Weight of Equity)
D/V = 40% (Weight of Debt)
Tax Rate = 20% (Tax Rate)

Using the formula above:

WACC = (0.60×10%) + (0.40×5% × (1?0.20))

WACC = 6% + 1.6%

WACC = 7.6%

Because the expected return on opening the new stores is 9%, and the WACC is 7.6%, the project is expected to generate enough profit to cover the cost of raising the capital to finance it.

Therefore, based on the WACC calculation, you should make the decision to move ahead with financing the new stores.

5 Variables That Affect WACC

Perceived riskInterest ratesChanges in tax rateEconomic changesCompany maturity

The higher the risk perceived by shareholders, the higher return they will demand on their investment.

The higher the interest rates, the more money it will cost to finance debt.

Because interest on debt is tax-deductible, if the corporate tax rate increases, it becomes more advantageous to finance capital via debt.

Inflation, stock market performance, and other economic conditions can influence the WACC calculation.

As a company matures, its risk management strategy changes, and is willing to take fewer risks in financing new projects and initiatives.

WACC vs. Required Rate of Return (RRR)

Feature	WACC	Required Rate of Return (RRR)
Definition	What a company is expected to pay to raise money through debt or equity	The minimum return an investor expects to justify the risk of a given investment
Used by	Companies to determine the cost to fund their operations or a new project	Investors to decide if an investment is worth the risk
Main components	Cost of equity Cost of debt	Equity returns Total returns
Answers the question…	Will this project earn more than it costs to fund?	Will this investment earn enough money for the risk I’m taking?
Calculation	Based on equity shares, loans, or other debt used to raise money	Based on models, like (Capital Asset Pricing Model), or criteria specific to the investor
Can change based on…	Changes in a company’s capital structure	An investor’s risk tolerance or market conditions
Takes taxes into consideration	Yes	No

WACC in Different Industries

The WACC calculation can be helpful in a variety of industries for a variety of reasons, such as:

Private equity

Can help estimate the value of a potential acquisition (also useful in venture capital).

Corporate finance

WACC can be used as the discount rate to calculate the present value of a company’s future cash flows in discounted cash flow (DCF) analysis.

Real estate

Helps developers decide on whether to finance a new construction project based on its expected returns.

Utilities

Suggests whether investment in new power plants, renewable energy projects, and other infrastructure is worthwhile.

Manufacturing

Can evaluate the financial viability of new production facilities.

Healthcare

Helps determine if an investment in new medical equipment or drug development is worthwhile.

Telecommunications

Determines if investment in new network infrastructure will generate returns that exceed their cost to finance.

WACC Limitations

While the WACC formula can be a helpful tool for companies to determine whether a new project or business initiative is viable, it shouldn’t be used as the only tool when making business decisions.

For one, WACC depends on estimations and projections of investment returns, the cost of equity, and more, which can’t be known in advance. It also fails to accurately account for changes in interest rates, investor expectations, and market conditions.

Also, WACC may not be a good tool for high-growth companies whose earnings are volatile and rely heavily on equity investment to finance their operations.

The Bottom Line

Based on the weighted average cost of capital definition, it seems like a perfect tool to help companies make business decisions based on their costs and projected future returns.

However, WACC can’t be used alone since it doesn’t take market and economic factors into account, and may not be the best tool in every situation. Companies can consider using the WACC formula, along with other financial calculations, to make more informed business decisions.