What is weighted average cost of capital?
The weighted average cost of capital (WACC) is a financial metric that calculates the average rate of return a company must earn on its existing assets to satisfy its creditors and shareholders. The WACC is used as a discount rate when valuing future cash flows of a company.
The WACC takes into account the relative weights of each source of financing, such as debt and equity, to come up with a single number that represents the company's cost of capital. This number can be used to compare different companies or projects to see which one offers the best return.
The weighted average cost of capital is also known as the weighted average cost of funds.
How is weighted average cost of capital calculated?
There are two steps in calculating the weighted average cost of capital: first, the cost of each source of financing is determined, then these costs are weighted according to their respective importance in the company's capital structure.
The cost of each source of financing is the required rate of return that must be earned on that particular type of investment. For example, the cost of equity is the minimum return that shareholders expect to receive for investing in the company. This can be calculated using the capital asset pricing model (CAPM).
The cost of debt is the interest rate that must be paid on loans and other forms of debt. This can be calculated by looking at the company's bond yield or by using the interest rate on a similar debt instrument.
Once the cost of each source of financing has been determined, these costs are then weighted according to their importance in the company's capital structure. The weights are typically the market value proportions of each type of financing.
For example, if a company has $1 billion in equity and $500 million in debt, the weight of equity would be 0.67 (or 67%) and the weight of debt would be 0.33 (or 33%). The weighted average cost of capital would be the sum of the weighted costs of equity and debt.
So, if the cost of equity is 10% and the cost of debt is 5%, the weighted average cost of capital would be 8.5% ((0.67 x 10%) + (0.33 x 5%)).
What are the benefits of using weighted average cost of capital?
There are a number of benefits to using the weighted average cost of capital:
- It is a comprehensive metric that takes into account all sources of financing.
- It can be used to compare different companies or projects.
- It is a good discount rate to use when valuing future cash flows.
What are the drawbacks of using weighted average cost of capital?
There are also some drawbacks to using the weighted average cost of capital:
- It is a complex metric that can be difficult to calculate.
- It relies on estimates and assumptions, such as the cost of equity and the weighting of different sources of financing.
- It may not be the best metric to use in all situations.
How can I use weighted average cost of capital to make investment decisions?
The weighted average cost of capital can be used to make investment decisions in a number of ways:
- It can be used to choose between different investment opportunities. The investment with the highest return relative to its WACC is typically the better choice.
- It can be used to assess whether a project is worth undertaking. The present value of the project's cash flows must be greater than the project's cost of capital for it to be considered worthwhile.
- It can be used to choose the optimal mix of debt and equity financing. The lower the WACC, the better.
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