The weighted average cost of capital (WACC) is an umbrella measure of risk, valuation, and expected return. Often misunderstood, this valuable metric provides tremendous insight into a company.
What Is The Weighted Average Cost Of Capital?
Cost of capital is a metric by which investors measure the opportunity cost of their money. Management must provide shareholders a cost of capital above an equally risky investment. Furthermore, the WACC assigns proportionate weights to each category of capital.
Additionally, sources of capital include both common and preferred stock, and long-term debt, such as bonds. Firms used different capital structures depending on management decisions, or industry specifics. For example, come companies carry no debt, while other are extremely debt heavy.
Elements Of WACC
WACC is the average cost of raising money for a firm. The equation for this calculation is:
WACC = (E/V) *Re + (D/V * Rd) * (1-T)
Where: E/V = % of equity financing , D/V = % of debt financing, Re = cost of equity, Rd = cost of debt, T = corporate tax rate
Also, E = market value of the company’s equity, D = market value of the company’s debt, and V = E + D.
Cost of equity is the return that the market demands for owning risky assets in a company. This measure comes with a bit of ambiguity compared to debt returns, which have set interest payments and values. The cost of equity is from the company point of view. If they fail shareholders and provide a lower rate of return, investors sell stock, hurting the company.
Cost of Debt is more simple. Interest paid on loans, minus the amount of taxes saved as a part of deductions, represents the cost of debt for a company.
Also, Management uses WACC, similar to cost of capital, in making decisions in order to maximize shareholder value.
Final Thoughts
Finally, the weighted average cost of capital represents an investor’s opportunity cost of taking risk. It is an ever-changing, somewhat subjective measure of judging risk and attracting the most capital available.
