Weighted Average Cost of
Capital (WACC)
The Weighted Average Cost of
Capital (WACC) can be explained as the rate expected to be
provided by a company on average to all the security holders for
financing its assets. The WACC is, basically, the minimum return
that should be essentially earned by a company on any existing
asset base so as to gratify its owners, creditors, as well as other
capital providers.
- A high weighted average cost of
capital, or WACC, is typically a signal of the higher risk
associated with a firm's operations. Investors tend to require an
additional return to neutralize the additional risk.
- A company's WACC can be used to
estimate the expected costs for all of its financing. This includes
payments made on debt obligations (cost of debt financing), and the
required rate of return demanded by ownership (or cost of equity
financing).
- Most publicly listed companies have
multiple funding sources. Therefore, WACC attempts to balance out
the relative costs of different sources to produce a single cost of
capital figure.
- In theory, WACC represents the
expense of raising one additional dollar of money. For example, a
WACC of 3.7% means the company must pay its investors an average of
$0.037 in return for every $1 in extra funding.
- Here is a more thorough example of
a company that needs money for growth: Imagine a newly-formed
widget company called XYZ Industries that must raise $10 million in
capital so it can open a new factory. So the company issues and
sells 60,000 shares of stock at $100 each to raise the first
$6,000,000. Because shareholders expect a return of 6% on their
investment, the cost of equity is 6%. XYZ then sells 4,000 bonds
for $1,000 each to raise the other $4,000,000 in capital. The
people who bought those bonds expect a 5% return, so XYZ's cost of
debt is 5%.
- The more complex a company's
capital structure, the more complex and onerous the WACC
calculation will be. But it’s a process well worth undertaking
because it can pave the pay for successful and profitable
operations.
- WACC is an important consideration
for corporate valuation in loan applications and operational
assessment. Companies seek ways to decrease their WACC through
cheaper sources of financing. For example, issuing bonds may be
more attractive than issuing stock if interest rates are lower than
the demanded rate of return on the stock.
- Value investors might also be
concerned if a company's WACC is higher than its actual return.
This is an indication the company is losing value, and there are
probably more efficient returns available elsewhere in the
market.
- Taxes can be incorporated into the
WACC formula, although approximating the impact of different tax
levels can be challenging. One of the chief advantages of debt
financing is that interest payments can often be deducted from a
company's taxes, while returns for equity investors, dividends or
rising stock prices, offer no such benefit.
Pros and cons of weighted
average cost of capital
The cost of equity value holds
scrupulous relevance for WACC. The market value of equity, not
being static, creates a variation in the true cost of capital
thereby resulting in an inaccurate estimate for the cost of
capital. However, calculating WACC is, undoubtedly, helpful in
providing a strong estimate if the exact figure is not obtained
from the calculation of WACC. Idyllically, a lower percent of WACC
is better for the company. Besides, calculating the weighted
average cost of capital also serves as a metric that can be
compared against the cost benchmark. Moreover, it should be
essentially noted that the numbers involved in the WACC equation
can, sometimes, prove to be misleading.
To wrap up, the Weighted Average
Cost of Capital is a measure used in finance for quantifying the
cost distribution percentage for different sources of finance. In
real meaning, the average cost of capital is ‘weighted’ on the
basis of the proportional amount of apiece form of capital.