Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) can be explained as the rate expected to be provided by a company on average to all the security holders for financing its assets. The WACC is, basically, the minimum return that should be essentially earned by a company on any existing asset base so as to gratify its owners, creditors, as well as other capital providers.
The different sources helpful for companies in raising finance include straight debt, common equity, convertible debt, preferred equity, warrants, options, exchangeable debt, pension liabilities, executive stock options, and similar more.
The Weighted Average Cost of Capital can be calculated by the use of a tax deduction to obtain the after tax cost of capital. Besides, it might also include a cost of equity component which can be calculated by various different methods.
The Weighted Average Cost of Capital is calculated using the following formula:
Where N represents the number of sources of finance; ri represents the required rate of return for security i; and MVd represents the market value for all outstanding securities i.
Pros and cons of weighted average cost of capital
The cost of equity value holds scrupulous relevance for WACC. The market value of equity, not being static, creates a variation in the true cost of capital thereby resulting in an inaccurate estimate for the cost of capital. However, calculating WACC is, undoubtedly, helpful in providing a strong estimate if the exact figure is not obtained from the calculation of WACC. Idyllically, a lower percent of WACC is better for the company. Besides, calculating the weighted average cost of capital also serves as a metric that can be compared against the cost benchmark. Moreover, it should be essentially noted that the numbers involved in the WACC equation can, sometimes, prove to be misleading.
To wrap up, the Weighted Average Cost of Capital is a measure used in finance for quantifying the cost distribution percentage for different sources of finance. In real meaning, the average cost of capital is ‘weighted’ on the basis of the proportional amount of apiece form of capital.