Weighted Average Cost of Capital (WACC)

 The Weighted Average Cost of Capital (WACC) is the average rate a company is expected to pay to all its investors, including both debt and equity holders, to finance its assets.¹ It represents the blended cost of a company's capital, considering the proportion of each funding source in its overall capital structure.²

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Key Components

• Cost of Equity: This is the return that a company's equity investors (shareholders) expect to earn for the risk they take.³ It's often determined using models like the Capital Asset Pricing Model (CAPM).⁴

• Cost of Debt: This is the effective interest rate a company pays on its debt.⁵ It's often the interest rate on loans or bonds, adjusted for the tax benefits of interest payments.⁶ Since interest expenses are tax-deductible, the after-tax cost of debt is used in the WACC calculation.⁷

• Weights: The WACC calculation is a weighted average, so it considers the proportion of the company's funding that comes from equity and the proportion that comes from debt.⁸ These weights are based on the market values of the company's equity and debt, not their book values.⁹

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Importance

WACC is a critical tool for financial decision-making for several reasons:

• Investment Decisions: It serves as the discount rate in Net Present Value (NPV) and other valuation models.¹⁰ It's often used as a hurdle rate, meaning a company will only undertake a new project if the expected return on that project is higher than its WACC.¹¹ If a project's return is less than the WACC, it's not generating enough value to satisfy the company's investors.¹²

• Company Valuation: WACC is used to determine a company's value.¹³ By discounting a company's future cash flows using its WACC, analysts can arrive at a valuation for the entire firm.¹⁴

• Performance Benchmark: A company's WACC can be used to measure its financial performance.¹⁵ If a company consistently earns returns above its WACC, it's creating value for its shareholders.¹⁶