The weighted average cost of capital (WACC) signifies the average anticipated return a company foresees on its forthcoming investments. It's derived by considering the current mix of a company's debt and equity, coupled with the respective costs of debt and equity capital for each financing type.
Calculating the formula for WACC
Determining a company's cost of capital is achieved through the WACC formula, taking into account the company's debt and equity financing structure. The formula is as follows:
WACC = (1 - t) * (D/V) * Kd * (1 - t) + t * E/V * Ke
- D = company's debt
- V = company's total value
- Kd = company's cost of debt
- Ke = company's cost of equity
- t = company's tax rate
Applications of WACC
WACC serves as the average of all financing sources a company utilizes. It aids in determining the return demanded by shareholders, considering the risk associated with the company's assets and the mix of debt and equity financing.
Who utilizes WACC?
Businesses employ WACC to gauge the average capital cost from diverse finance sources. It encompasses risk evaluation for each financing type and the expected return demanded by investors. Companies leverage WACC to decide between debt and equity financing, striving for the lowest possible WACC and employing it to ascertain a business's value.
Distinguishing WACC from WAC
WACC, the weighted average cost of capital, evaluates costs from various financing sources in proportion to their usage. In contrast, WAC—weighted average cash flow—considers cash flows from financing sources in line with their usage but doesn’t encompass the cost aspect.