What is weighted average cost of capital (WACC)?

Weighted average cost of capital (WACC) is the computation of company’s cost of capital of each category of capital corresponds to weight. It includes common stock, preferred stocks, bonds and other long term debts. In other words, WACC is the average rate of a company pay to its investors.

Increase in WACC means increase in risk. WACC uses by security analysts to assess the value of investment and to determine the pursue. It is also essential to calculate economic value added (EVA). Investors may use WACC to make decisions whether to invest or not. WACC tells about cost of new projects or existing projects.

Formula

WACC = (percentage of financing that is equity)*cost of equity +
   (Percentage of financing that is debt)*cost of debt*(1-corporate tax)
WACC = (E/V)*Re + (D/V)*Rd*(1-corporate tax)

Components of WACC

• Risk free rate − Risk free rate don’t have any objective existence; it is estimated by means of approximations. These approximations are yield on government bonds, which are issued on local currency.

• Debt risk premium − It is the additional amount to risk free rate paid to their debt holders to compensate risk. It is easy to assess. These are studied by investment banks, stock brokers and other institutions.

• Equity risk premium − It is the premium amount paid to equity holders for compensating the risk, volatility, uncertainty of invests in stock markets.

• The beta − It is the risk multipliers used by firms know as beta. Where equity risk premium is multiplied by risk multiplier to get firms specific returns. Beta measures volatility of company share value to volatility of stock market

• Debt-equity ratio − The debt-equity ratio tells about the weights in WACC.

• Tax rate − Act as tax shield and reduces the cost of debt capital.

Types of WACC are as follows −

• Marginal weighted average cost of capital

• Optimal weighted average cost of capital