Weighted average cost of capital

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 dictated by the external market and not by management. The WACC 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. 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 dictated by the external market and not by management. The WACC 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. In general, the WACC can be calculated with the following formula: WACC = ∑ i = 1 N r i ⋅ M V i ∑ i = 1 N M V i {displaystyle { ext{WACC}}={frac {sum _{i=1}^{N}r_{i}cdot MV_{i}}{sum _{i=1}^{N}MV_{i}}}} where N {displaystyle N} is the number of sources of capital (securities, types of liabilities); r i {displaystyle r_{i}} is the required rate of return for security i {displaystyle i} ; and M V i {displaystyle MV_{i}} is the market value of all outstanding securities i {displaystyle i} . In the case where the company is financed with only equity and debt, the average cost of capital is computed as follows: WACC = D D + E K d + E D + E K e {displaystyle { ext{WACC}}={frac {D}{D+E}}K_{d}+{frac {E}{D+E}}K_{e}} where D {displaystyle D} is the total debt, E {displaystyle E} is the total shareholder's equity, K d {displaystyle K_{d}} is the cost of debt, and K e {displaystyle K_{e}} is the cost of equity. The market values of debt and equity should be used when computing the weights in the WACC formula.