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. In general, the WACC can be calculated with the following formula:

WACC = $\Large (\frac{\text{Equity}}{\text{Equity}+\text{Debt}} * \text{Cost of equity}) + (\frac{\text{Debt}}{\text{Equity}+\text{Debt}} * \text{Cost of debt}) * (1-\text{Company Tax Rate})$

Example of WACC calculation, Suppose the following situation in a company:
* The market value of debt = €300 million
* The market value of equity = €400 million
* The cost of debt = 8%
* The corporate tax rate = 35%
* The cost of equity is 18%
The WACC of this company is:
{{{
400 : 700 * 18%
+   300 : 700 * 8% * (1-35%)
------------------------------------------------
12,5% (WACC - Weighted Average Cost of Capital)
}}}

[[Equity]] and [[Debt]] can be looked up at the companies [[Balance Sheet]]

The easy part of WACC is its debt part. In most cases it is clear how much a company has to pay their bankers or bond holders for debt finance. More difficult however, is the cost of equity finance. Normally, the cost of equity capital is higher than the cost debt finance, because equity involve a risk premium

!Application of the WACC
Corporations create value by earning
* a return on the invested capital that is
* //above// the cost of that capital.

The WACC (Weighted Average Cost of Capital) is an expression of this cost. It is used to see if value is added when certain intended investments or strategies or projects or purchases are undertaken. WACC is expressed as a percentage, like interest. For example, if a company works with a WACC of 12%, than this means that only investments should be made and all investments should be made, that give a return higher than the WACC of 12%.

The [[Costs of Capital]] for any investment, whether for an entire company or for a project, is the rate of return which capital providers would want to receive if they would invest their capital elsewhere. In other words, costs of capital are a type of [[Opportunity Cost]]

Factors that make calculating WACC difficult:
# Calculating this risk premium is one thing that makes the calculation of WACC complicated.
# Another important complication is which mix of debt and equity should be used to maximize shareholder value. This is what "Weighted" means in WACC. See [[Four ways to weight capital]]
# Finally: also the corporate tax rate is important, because normally interest payments are tax deductible.
bag
finance_public
created
Sun, 06 Feb 2011 20:41:35 GMT
creator
dirkjan
modified
Sun, 06 Feb 2011 20:41:35 GMT
modifier
dirkjan
tags
M9
Term
creator
dirkjan