The Weighted Average Cost of Capital (WACC)

[latexpage]The weighted average cost of capital is defined as measuring the cost of capital where each category of capital is proportionally weighted and taken into consideration. Examples of some of the capital sources that are included in the calculation are; common stock, preferred stock, bonds and any other long-term debt. An increase in the weighted average cost of capital can have two negative side effects, (1) there is a decrease in valuation and (2) there is much higher risk. The WACC of a firm will increase if the rate of return on equity and beta increase as well. The following formula represents how the weighted average cost of capital is calculated:

$WACC = \dfrac {E}{(D+E)}\times R_e +\dfrac{D}{(D+E)} \times R_d \times (1-T_c)$

$R_e$ = cost of equity
$R_d$ = cost of debt
$E$ = market value of the firm’s equity
$D$ = market value of the firm’s debt

$\dfrac {E}{(D+E)}$ = percentage of financing that is equity

$\dfrac {D}{(D+E)}$ = percentage of financing that is debt

$T_c$ = corporate tax rate

After calculating the WACC, businesses often discount cash flows at WACC to figure out the Net Present Value (NPV). In simpler terms, it represents the average costs of the sources used in financing a company. By calculating the WACC, it allows companies to measure how much it costs to finance every dollar. The WACC can also be used as a hurdle rate against which to assess the return of investment capital performance. A hurdle rate is the minimum amount of return an individual will require before he decides to make an investment in something. It can be easily compared to a reservation wage, in which an individual will only work if the wage is at or above their reservation wage, except this concept is applied to investing. This rate of return will give the individual the ability to “get over the hurdle” and invest their money.