Weighted average cost of capital (WACC) refers to a calculation of the cost of a capital for a company. It involves every category of the company’s capital being weighed proportionately. Each source of capital for the relevant corporation will be considered by this designation. This means that preferred and common stock, bonds and all types of longer-term debt will all be included in the WACC calculation. It will go up with the rate of return on equity and beta increases. When the WACC increases, this means that the risk has increased while the valuation for a firm has decreased.
Calculating weighted average cost of capital requires taking each part of the capital components and multiplying them by their appropriate proportional weight. These individual calculations are then added together to come up with the WACC.
Companies can finance their needs through one of two main types of funding. This is either via equity issuing in the form of primarily stock shares or through debt issuance as with bonds. This measurement actually weights appropriately the two main forms of corporate financing, with each weighted according to its relevant utilization in a particular situation. It allows companies and analysts to decide how much every dollar they are financing will cost them in interest, making it imminently practical.
The reasons this is important are evident. The holders of equity and lenders of a corporation will demand specific minimal returns on their capital or lent money they have delivered. This is why WACC proves to be so useful. It shows the cost of capital for both the stake holders (as equity owners) and the lenders (as the debt holders). This means that both groups will be able to understand the levels and amounts in returns they can anticipate receiving. Another way of looking at the weighted average cost of capital is that this is the opportunity cost of any investor for assuming the risk which investing in the corporation entails.
A firm’s WACC represents the all around return on capital for the company. This means that the directors of the corporation will commonly utilize the numbers internally to make appropriate decisions for the organization. Such decisions might include evaluating opportunities for expanding the business or the financial practicality of engaging in an acquisition or a merger.
It is helpful to consider examples to best understand this complex concept of weighted average cost of capital. Assume that a corporation is a money pond. Money comes into this pond out of two separate streams which are the sources. These streams represent the equity and the debt of the company. Money which the daily business operations bring in does not count as another source. The reason for this logic is that once a firm pays down its debt, any remaining money that they do not pay out as dividends or for share buybacks becomes what analysts call retained earnings held in trust for the shareholders.
Consider lenders that want eight percent return for their funds they loaned to a given company. At the same time, the stakeholders possessing the stock share may want a minimum 16 percent return on their investments or they will not hold onto the shares of the company. This means that the projects which the corporation funds using its money pond will need to provide an annual recurring return of 12 percent so that both their lenders and equity holders will remain happy. This 12 percent represents the weighted average cost of capital.
Going back to our original example of the money pond, if it contained $100 in debt holder money and $100 in investments from shareholders, the company might invest $200 in one of its projects. They would then require an annual return of 12 percent total, or $24 from the project funded by the pond. This would mean that $16 of this return was for the share holders while $8 of the total return was for the debt holders.
The term 'Weighted Average Cost of Capital (WACC)' is included in the Corporate Finance edition of the Financial Dictionary. You can get your copy on mazon in Kindle or Paperback version. See more details here.