Weighted average cost of capital

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.

The WACC is 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. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC.

Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.

Calculation

In general, the WACC can be calculated with the following formula:

$\text{WACC} = \frac{\sum_{i=1}^N r_i \cdot MV_i }{\sum_{i=1}^N MV_i}$

where N is the number of sources of capital (securities, types of liabilities); r_i is the required rate of return for security i; MV_i is the market value of all outstanding securities i.

Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of MV_e and cost of equity R_e and one type of bonds with the total market value of MV_d and cost of debt R_d, in a country with corporate tax rate t is calculated as:

$\text{WACC} = \frac{MV_e}{MV_d+MV_e} \cdot R_e + \frac{MV_d}{MV_d+MV_e} \cdot R_d \cdot (1-t)$

See also

• Beta coefficient
• Cost of capital
• Discounted cash flow
• Economic Value Added
• Internal rate of return
• Minimum acceptable rate of return
• Modigliani-Miller theorem
• Net present value
• Opportunity cost

External links

• Video about practical application of the WACC approach
• Velez-Pareja, Ignacio and Tham, Joseph, "A Note on the Weighted Average Cost of Capital WACC" (August 7, 2005). Available at SSRN: http://ssrn.com/abstract=254587. Unpublished.
• Cheremushkin, Sergei Vasilievich, How to Avoid Mistakes in Valuation - Comment to 'Consistency in Valuation: A Practical Guide' by Velez-Pareja and Burbano-Perez and Some Pedagogical Notes on Valuation and Costs of Capital (December 21, 2009). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1526681. Unpublished.
• WACC calculator
• A more realistic valuation: APV and WACC with constant book leverage ratio
• calculate the WACC with your own values to understand the equation
• Find the WACC of any publicly traded company by entering the firm's stock ticker symbol
• Paper describing a method for generating the WACC curve when there is default risk - spreadsheet available