WACC stands for Weighted Average Cost of Capital. It is a financial metric that represents a company’s average cost of capital from all its sources, including debt and equity. WACC is often used in financial analysis and valuation, such as Discounted Cash Flow (DCF), to assess the required return on investment for a company or project.
WACC Formula:
WACC=(EV×Re)+(DV×Rd×(1−Tc))WACC = \left( \frac{E}{V} \times Re \right) + \left( \frac{D}{V} \times Rd \times (1 – Tc) \right)
Where:
- EE: Market value of equity (shares outstanding × share price)
- DD: Market value of debt (total debt obligations)
- VV: Total value of capital (equity + debt)
- ReRe: Cost of equity (return expected by equity investors)
- RdRd: Cost of debt (interest rate on debt)
- TcTc: Corporate tax rate
Key Components:
- Cost of Equity (ReRe):
- Estimated using the Capital Asset Pricing Model (CAPM): Re=Rf+β×(Rm−Rf)Re = Rf + \beta \times (Rm – Rf) Where:
- RfRf: Risk-free rate (e.g., government bond yield)
- β\beta: Measure of a stock’s volatility relative to the market
- Rm−RfRm – Rf: Equity market risk premium
- Estimated using the Capital Asset Pricing Model (CAPM): Re=Rf+β×(Rm−Rf)Re = Rf + \beta \times (Rm – Rf) Where:
- Cost of Debt (RdRd):
- Based on the interest rate a company pays on its debt. Adjusted for tax savings because interest payments are tax-deductible (Rd×(1−Tc)Rd \times (1 – Tc)).
- Proportions of Debt and Equity (EV\frac{E}{V} and DV\frac{D}{V}):
- The weights are based on the proportion of equity and debt in the company’s capital structure.
Why WACC Matters:
- Investment Decisions: Helps determine the hurdle rate for evaluating new projects. If a project’s return exceeds the WACC, it creates value.
- Valuation: Used as the discount rate in DCF to estimate the company’s intrinsic value.
- Risk Assessment: Reflects the company’s overall risk as perceived by investors and lenders.
In simple terms, WACC is the blended cost of financing for a company, considering both its debt and equity sources. A lower WACC means cheaper financing, which is typically favorable for the company.
