The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm’s cost of capital. Importantly, it is dictated by the external market and not by management. The WACC represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.
Weighted Average Cost Of Capital – WACC
Weighted average cost (WACC) calculates a firm’s cost of capital and proportionally weighs each category of capital. The WACC calculation includes a number of sources of capital like preferred stocks, long-term debt, common stock, and bond.
A company’s WACC gets an upward surge when there is an increase in the beta and the rate of return on equity. It is important to know that the increase in WACC shows an increase in risk and a decrease in the valuation.
Calculation of WACC
The WACC is calculated by multiplying the capital component by their weight, and then the sum of results is taken. WACC can be calculated with the help of the following formula:
WACC = (Equity / Total Capital) * Cost of Equity + (Debt / Total Capital) * Cost of Debt * (1 – Tax Rate)
Understanding Weighted Average Cost Of Capital WACC
Companies finance their assets with either equity or debt. WACC is the average of the costs of different types of financing, where each component is weighed by its usage in the given situation. This way it is easy for companies to know how much interest they owe for every dollar they finance. Debt and equity make up a company’s capital funding and investors expect to get returns on their investments. Cost of capital is the returns that the shareholders expect, and WACC informs about the kind of returns that they can expect.
Uses of Weighted Average Cost of Capital (WACC)
WACC is used to see the value of investments, so that the stakeholders can understand what kind of investments they should pursue. It is an indicator that helps in determining the acceptable rate of return at which the company should yield the returns for their shareholders. It gives investors a reality check but in order to accurately calculate the WACC, one needs detailed company information. Another thing that investors should know is that certain values like the cost of equity are not consistent and different people report them differently.
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- “The weighted average cost of capital is not quite right”: A comment – www.sciencedirect.com [PDF]
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