Question

what is wacc? how do company use them for their finance?

for example if wacc=10.50%

the risk free rate of return is 2.34% snd return on the market is 7.5% what does this wacc mean to the company ?

Answer 1

WACC is an acronym for weighted average cost of capital of a firm. A firm's funds are composed of capital from different sources like common stock, debt and retained earnings. Raising all such capital requires a cost that the company has to bear, for example: a company needs to pay interest on a certain rate and basis like yearly to raise capital through debt. Similarly, a company pays dividends to its equity holders. All such costs in to accounted, WACC takes the average cost of raising capital through each of such sources along with the percentage of capital in overall capital funding. Suppose, company has cost of equity of 10% and 10% of equity capital in its total capital. In that case, its WACC is 10% * 10% i.e. 1%. This is a simple example, usually, there are several sources and respective costs involved in ascertaining WACC.

Companies uses WACC as a benchmark of expected return of its investors as well as to strategize investment decisions to generate revenue in future. Now, coming to the example provided, if WACC is 10.50%, risk free rate is 2.34% and return on the market is 7.5%, it means that the company needs to provide atleast a return of 10.5% to its investors while the return from market and risk free rate of return is 7.5% and 2.34% respectively. The company needs to realise that its investors are compromising a market return of 7.5% and bearing more risk by investing in the company to expect a return 10.5%. An investor can easily investor its funds on a risk free basis and earn a return of 2.34%, however it chose to bear risk and hopes to earn a minimum of 10.5%.