The weighted average cost of capital (WACC)
is the rate that a company is expected to pay on average to all its security
holders to finance its assets. The WACC is commonly referred to as the firm’s cost of capital. Importantly, it is not dictated by
management. Rather, it represents the minimum return that a company must earn
on an existing asset base to satisfy its creditors, owners, and other providers
of capital, or they will invest elsewhere.
Companies raise money from a number of sources:common stock, preferred stock, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC.
Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.
Basic formula for WACC :
= ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
E = of the company's equity
D = of the company's debt
V = Total of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate
A company is typically financed using a combination of debt (bonds) and equity(stocks). Because a company may receive more funding from one source than another, we calculate a weight average to find out how expensive it is for a company to raise the funds needed to buy buildings, equipment, and inventory.
Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000 shares of stock at $100 each to raise the first $600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.
Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital. The people who bought those bonds expect a 5% return, so ABC's cost of debt is 5%.
Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) = $1 million and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation ABC's weighted average cost of capital (WACC).
= (($600,000/$1,000,000) x .06) + [(($400,000/$1,000,000) x .05) * (1-0.35))] = 0.049 = 4.9%
Corporation ABC's weighted average is 4.9%.
This means for every $1 Corporation ABC raises from investors, it must pay its investors almost $0.05 in return. It's important for a company to know its weighted averagel as a way to gauge the expense of funding future projects. The lower a company's, the cheaper it is for a company to fund new projects.
Reference : Wikipedia Encyclopedia, investinganswers.com, investopedia.com