What is WACC?
The Weighted Average Cost of Capital (WACC) is the average rate of return a company is expected to pay to its investors (both debt and equity holders) to finance its assets. WACC represents the company's cost of funding from all sources, including debt, equity, and sometimes preferred equity, each weighted by its proportion in the company's capital structure.
WACC is an important metric for evaluating investment opportunities, valuing companies, and assessing whether a company is generating sufficient returns to meet the expectations of its investors. It is used to discount future cash flows in financial models like Discounted Cash Flow (DCF) analysis.
How is WACC Calculated?
WACC is calculated by taking the cost of each source of capital (debt, equity, etc.), multiplying it by the proportion of the total capital it represents, and summing them together. The formula for WACC is:
Where:
E= Market value of the company’s equityV= Total market value of equity and debtRe= Cost of equityD= Market value of the company’s debtRd= Cost of debtTc= Corporate tax rate
This formula reflects the weighted contributions of equity and debt to the company’s overall capital and takes into account the tax benefits of debt financing.
Why is WACC Important?
WACC is critical for several reasons:
Investment Evaluation: WACC is used as a hurdle rate when evaluating investment projects. If the expected return on a project exceeds the company’s WACC, the project is considered to add value; otherwise, it may destroy value.
Valuation: In valuation models like DCF, WACC is used as the discount rate to calculate the present value of future cash flows. A lower WACC increases the present value, making the company or project more valuable.
Capital Structure Decision-Making: WACC helps a company decide on its capital structure by balancing the use of debt and equity. Debt is typically cheaper than equity, so companies often aim to optimize their debt-to-equity ratio to lower WACC, improving shareholder value.
Performance Benchmark: WACC serves as a benchmark for measuring the company’s return on capital. If a company’s return on invested capital (ROIC) is higher than its WACC, it’s generating value for shareholders.
Risk and Return: WACC reflects the risks associated with the company's capital structure. Companies with higher risk profiles (e.g., those with volatile earnings or significant debt) will generally have a higher WACC, as investors demand higher returns for taking on additional risk.