Weighted Average Cost of Capital (WACC)
Definition of 'Weighted Average Cost of Capital (WACC)'
Weighted average cost of capital is widely used to determine how much a company should borrow as well as the necessary returns it must get when it invests in new projects. It shows the company’s cost of capital, given the structure of both its debt and equity.
TheStreet Explains ‘Weighted Average Cost of Capital (WACC)’
To determine a company’s WACC, multiply the cost of each component of capital by its proportional weight and add the sum. The formula for WACC is: E/V*Re + D/V*Rd*(1-Tc) where E is the market value of equity, D is value of debt, V equals D plus E, Re is the cost of equity and Rd is the cost of debt. Tc is the corporate tax rate. The cost of debt capital is reduced by the corporate tax rate because interest payments are tax deductible, so become less costly after taxes.
Determining WACC is trickier than it seems because cost of equity isn’t straightforward while cost of debt is. Cost of equity is basically the return shareholders demand to keep their money invested in the company. This varies from company to company and industry to industry. Nonetheless, determining WACC is a valuable exercise. Investors can use WACC to determine whether management is making good or bad decisions when it invests in a new project. For instance if a company’s WACC is 10% and it will get a return of 9% on a new project, it is actually losing money on the investment. Conversely, if the return on the new project is above 10%, it may be worth making the investment.
WACC can also be used to determine the most rational proportion of debt to equity a company needs to fund projects. In recent years, many companies have become highly levered, or taken on debt, because of a widely held belief that the cost of debt is lower than the cost of equity. This happens when interest rates are low, but investors see equity investments as riskier.
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