The weighted average cost of capital, or WACC, is a key business metric, usually expressed as a percentage or ratio, that measures the costs associated with raising funds through different revenue streams.
Companies raise funds through two distinct methods. They borrow money by issuing bonds, which is a loan, or they sell shares, or title deeds, equity interests. The WACC is an important tool for determining the costs associated with raising capital through these methods and is used by investors and financial analysts to assess typical financing costs for a given company.
Expenses associated with capitalizing a business – such as the costs associated with borrowing money or issuing stock – should not be overlooked. The WACC percentage ratio tells investors how much a company is spending to finance its current operations and allows them to estimate the costs of issuing additional stock or bonds in the future.
Many factors affect WACC, but in general, a strong company with reliable revenues and strong profits will have a lower WACC than a weaker company. It follows that investing in a company with a relatively high WACC carries more risk than investing in companies with a lower WACC. Indeed, companies that spend excessive amounts on debt or equity financing have less money to devote to their growth and operations.
The WACC is important for large equity investors such as mutual funds and institutional bond investors such as insurance companies. However, small retail investors can benefit from understanding the concepts behind WACC.
Because WACC takes into account the proportional weight of equity and debt against an ever-changing market value, calculating WACC is not straightforward.
The first step is to establish the costs of borrowing and raising capital separately. The next step is to determine the proportion or “weight” of each relative to the market value. Once these two variables have been determined, they are each multiplied by their corresponding market weight. The figures obtained are added together and this sum is multiplied by the corporate tax rate of the company. Thus, a current WACC can be achieved.
- E = market value
- D = market value of debt
- T = corporate tax rate
- Re = Cost of equity
- Rd = Cost of debt
- V = E + D
Expressed as a formula, the calculation would look like this: (E ÷ D × Re) + (D ÷ V × Rd x [1 – T]) = WACC
Different types of debt or equity securities, such as preferred shares, which are shares with a preferential dividend payment but without voting rights, or convertible shares or bonds, which are shares that can be converted into bonds or , conversely, bonds that can be converted into stock, will complicate WACC calculations and require different formulas.
The WACC becomes more important as more money is invested. Institutional investors rely heavily on WACC, but understanding the basics of WACC can also be useful for retail investors.