Question

What is WACC (weighted average cost of capital) and how do companies make financial decisions based on it?

Answer 1

Answer : WACC is the weighted average of cost of a company’s debt and the cost of its equity. A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added together.

WACC is used in financial modeling as the discount rate to calculate the net present value of a business.

WACC Formula = (E/V * Ke) + (D/V) * Kd * (1 – Tax rate)

• E = Market Value of Equity
• V = Total market value of equity & debt
• Ke = Cost of Equity
• D = Market Value of Debt
• Kd = Cost of Debt
• Tax Rate = Corporate Tax Rate

Companies make financial decisions based on WACC by using and calculating the formula mentioned above :

The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunity cost. Thus, it is used as a hurdle rate by companies.

A company will commonly use its WACC as a hurdle rate for evaluating mergers and acquisitions (M&A), as well financial modeling of internal investments. If an investment opportunity has a lower Internal Rate of Return (IRR) than its WACC, it should buy back its own shares or payout a dividend instead of investing in the project.