What Is Weighted Average Cost of Capital?

Weighted Cost of Capital is the average rate a company pays for the different types of capital such as stocks and bonds that it uses to fund new projects and expand its operating activities. WACC or Weighted Average Cost of Capital is the sum of the different capital costs weighted by the market value of each capital component.

For those with a limited financial background, WACC is the metric that tells the company what level of profit it should be aiming for to offset its various capital expenditures.

How Is WACC Calculated?

The standard WACC formula is:

WACC = (E/V × Re) + (D/V × Rd × (1 − Tc))

Where:

E = Market value of equity

D = Market value of debt

V = Total capital (E + D)

Re = Cost of equity

Rd = Cost of debt

Tc = Corporate tax rate

WACC Calculation Example

Suppose a company has:

• Equity: $8 million
• Debt: $4 million
• Cost of equity: 10%
• Cost of debt: 6%
• Corporate tax rate: 25%

First, calculate total capital:

V = $8 million + $4 million = $12 million

Now apply the WACC formula:

WACC = (8/12 × 10%) + (4/12 × 6% × (1 − 25%))

WACC = 6.67% + 1.50%

WACC = 8.17%

The company’s WACC is therefore 8.17%. This means a new investment would generally need to generate a return above this benchmark to have the potential to create value, assuming other relevant factors remain unchanged.

Why Is WACC Important?

WACC helps businesses evaluate the financial attractiveness of major decisions. It can be used to:

• Evaluate investments: Compare expected project returns with the company’s financing cost.
• Support business valuation: WACC can serve as a discount rate in certain valuation models.
• Assess financing choices: Understand the financial impact of using more debt or equity.
• Guide expansion decisions: Determine whether new projects or investments may generate sufficient returns.
• Measure value creation: Returns above WACC may indicate that an investment is creating value.

Generally, an investment expected to generate returns above the company’s WACC may create value, while a return below WACC may indicate that the investment requires further evaluation.

What Can Affect WACC? 

Weighted Average Cost of Capital (WACC) may fluctuate with variations in rates of interest, debt levels, business risk, external market conditions, or the value at which the investors’ return can be estimated (cost of equity). 

Because of this, corporate finance managers should consider revising not only their financial structure but also assumptions on a regular basis, instead of assuming that WACC is a constant figure.

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