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What is WACC?
Weighted Average Cost of Capital (WACC) represents a company’s blended cost of raising capital from both debt and equity sources. It acts as a benchmark rate businesses use to evaluate investments, value companies, and make financing decisions.
Definition
WACC is the average rate a company expects to pay to finance its assets, weighted by the proportion of debt and equity in its capital structure.
Key Takeaways
- WACC shows the minimum return a business must earn to satisfy investors and lenders.
- It ties directly to company valuation, capital budgeting, and discount rate selection.
- Lower WACC means cheaper capital and greater valuation potential.
Understanding WACC
WACC blends costs across debt and equity. Debt is typically cheaper due to tax deductibility of interest, while equity is more expensive because shareholders require higher returns. The weighting of each source of funds determines the final WACC value.
Companies use WACC as a hurdle rate in capital budgeting. If a project’s expected return exceeds WACC, it creates shareholder value; if it falls below WACC, it destroys value. Investors also use WACC in discounted cash flow (DCF) models to estimate the present value of future earnings.
WACC changes over time based on interest rates, risk environment, company leverage, and market return expectations. Firms aim to optimize capital structure to minimize WACC and maximize valuation.
Formula (If Applicable)
WACC Formula:
WACC = (E/V × Re) + (D/V × Rd × (1 – Tc))
- E = Market value of equity
- D = Market value of debt
- V = Total capital (E + D)
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
Real-World Example
Apple or Amazon may use WACC when deciding whether to invest in new data centers or supply chain expansions. If the expected project return rises above their WACC, the investment is considered value accretive.
Importance in Business or Economics
WACC affects valuation, strategic investments, and financing decisions. Companies track it closely to ensure optimal capital structure. Investors use it to compare firms and evaluate risk levels.
Types or Variations (If Relevant)
- Pre-tax WACC: Excludes tax benefits.
- After-tax WACC: Reflects tax-deductible interest expense.
- Marginal WACC: Cost of raising additional capital.
Related Terms
- Cost of Equity
- Cost of Debt
- Capital Structure
Sources and Further Reading
- Investopedia: https://www.investopedia.com/terms/w/wacc.asp
- Corporate Finance Institute (CFI): https://corporatefinanceinstitute.com/resources/knowledge/finance/wacc/
- Harvard Business Review: https://hbr.org/
Quick Reference
- WACC blends equity and debt costs.
- Used as a discount rate in DCF valuation.
- Lower WACC generally increases company valuation.
Frequently Asked Questions (FAQs)
What does WACC measure?
It measures a company’s blended cost of financing from debt and equity.
Why is WACC important?
It guides investment decisions, valuation, and capital structure planning.
Does a lower WACC always mean better performance?
Not always, but it usually indicates cheaper financing and higher valuation potential.
