What Is the Weighted Average Cost of Capital?

What Is the Weighted Average Cost of Capital?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

The Weighted Average Cost of Capital (WACC) is a financial metric, which is the average rate of return a company is expected to provide to all of its stakeholders, including creditors, bondholders, and shareholders. WACC combines the company’s cost of equity and cost of debt in proportionate ratios to come up with this average amount.

The company’s cost of equity represents the compensation the market demands in exchange for owning the asset and facing the risk. On the other hand, the cost of debt is basically the effective rate that a company pays on its current debt.

In simple terms, WACC provides companies with a measure of how much interest the company has to pay for every dollar it finances.

Related Questions

1. How is WACC calculated?

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The WACC is calculated by multiplying the cost of each capital source (debt and equity) by its respective weight, and then adding the results.

2. Why is WACC important for an investor?

WACC is crucial to investors because it provides insight into the hurdle rate used by a company when determining an investment’s potentials. The investor can match this rate against the prospective return of an investment to see if the enterprise is a worthwhile risk.

3. Can a negative WACC be possible?

No, a negative WACC is not practically possible because the costs of capital (debt and equity) cannot be negative.

4. What does a high WACC indicate?

A high WACC indicates that a company must pay more to finance its assets. Therefore, high WACC can be a sign of higher investment risks.

5. How can a company reduce its WACC?

A company can reduce its WACC by lowering the cost of equity or cost of debt, or changing the capital structure to weight more heavily in the cheaper source of financing.