Weighted average cost of capital (WACC)

Definition

Weighted Average Cost of Capital (WACC) is the average rate of return a company is expected to pay its security holders to finance its assets. It reflects the cost of equity and debt, weighted by their respective proportions in the company's capital structure.

5 Must Know Facts For Your Next Test

1. WACC is used to evaluate investment opportunities; a project is considered favorable if its return exceeds WACC.
2. Components of WACC include the cost of equity, cost of debt, and the proportionate weights of each in the total capital structure.
3. The formula for WACC is WACC = (E/V * Re) + ((D/V * Rd) * (1-T)) where E is market value of equity, V is total value of equity and debt, Re is cost of equity, D is market value of debt, Rd is cost of debt, and T is tax rate.
4. A lower WACC indicates cheaper financing costs for the company, which can lead to higher valuations.
5. Changes in interest rates or shifts in market conditions can affect both the cost components and overall WACC.

Review Questions

• What components are used to calculate WACC?
• Why would a company prefer a lower WACC?
• How does an increase in interest rates typically affect WACC?

Related terms

Cost of Equity: The return required by shareholders for investing in a company's equity.

Cost of Debt: The effective rate that a company pays on its borrowed funds.

Capital Structure: The mix of debt and equity financing used by a company.