The Weighted Average Cost of Capital (WACC) is a financial metric that represents the average cost of financing a company’s assets, considering both debt and equity components.
Page written by Ian Hawkins. Last reviewed on June 24, 2024. Next review due October 1, 2025.
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The weighted average cost of capital (WACC) is the average rate of return a company is expected to pay its investors (both equity and debt holders) for using their capital. It represents the company’s cost of financing and is a crucial metric for evaluating investment opportunities and overall financial health.
Investment appraisal: Companies use WACC to evaluate the feasibility of new projects. It serves as a hurdle rate; if the expected return on an investment exceeds the WACC, the project is considered worthwhile.
Valuation: WACC is used in discounted cash flow (DCF) analysis to calculate the present value of future cash flows. This helps in determining the fair value of a company or its assets.
Performance Measurement: WACC helps in assessing whether a company is generating value for its shareholders. If a company’s return on invested capital (ROIC) is higher than its WACC, it is creating value.
Capital Structure Decisions: It aids in deciding the optimal mix of debt and equity financing. Companies aim to lower their WACC by adjusting their capital structure, thereby maximizing shareholder value.
Risk assessment: Investors use WACC to gauge the risk of investing in a company. A lower WACC typically indicates a lower risk investment.
To calculate the weighted average cost of capital:
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