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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
WACC Components
There are several factors that play a role in the calculation of WACC.
These include:
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
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 |
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| 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:
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.
