Weighted Average Cost of Capital (WACC)

The average cost of a particular fund can be used to define the cost of capital, which is the total composite cost of capital. The term “weighted average cost of capital” (WACC) refers to the cost of borrowing from several sources, with each source’s market value serving as the weight. The returns that each investor expects to receive are referred to as the cost of various sources of finance.

The average cost of a company’s financing (stock, debentures, bank loans) weighted in accordance with the contribution each component makes to the total pool of capital is known as the “weighted average cost of capital.” Normal weighting is determined by market valuation, current yields, and costs after taxes.

Weighted Average Cost of Capital vs Specific Cost of Capital

A company can get funds from a number of sources. The cost of capital for each source of capital varies due to the variances in risk and the contractual arrangements between the company and investors. Component or specific cost of capital refers to the cost of capital for each source of funding.

The overall or average cost of capital is the total cost of all capital sources. To get the average cost of capital, the component costs are added together based on the weight assigned to each component of capital. As a result, the whole cost is often known as the weighted average cost of capital (WACC).

Importance of Weighted Average Cost of Capital (WACC)

The firm’s overall cost of capital is crucial since it will be used to evaluate capital budgeting plans as the discount or cut-off rate. The rate of return that the company must achieve in order to meet the demands of the various investors can be used to define the overall cost of capital. Thus, the minimum required rate of return on the firm’s assets is equal to the overall cost of capital.

Calculation of the Weighted Average Cost of Capital (WACC)

The proportional share of various sources in the firm’s capital structure should be taken into account by this total cost of capital. As a result, the weighted average of the various individual costs of capital should be used to calculate the total cost of capital rather than the simple average.

The stages involved in determining the firm’s WACC are as follows:

  • Determine the cost of particular funding sources.
  • Multiply each source’s cost by the capital structure’s share of it.
  • To calculate the WACC, add the weighted component costs.

The cost of capital should be determined on an after-tax basis when making financial decisions. So the after-tax costs should be the component costs.

The following formula is used to calculate the WACC:

WACC = (Cost of equity X % equity) + (cost of debt X % debt) + (Cost of equity X % equity)

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