# What is the weighted average cost of capital?

**Weighted Average Cost of Capital(WACC)** is a financial metric for a companyâ€™s operation. This financial metric represents the average cost of all capital components used to finance the companyâ€™s activities. Do you know How to Calculate Weighted Average Cost of Capital? which will be calculated by taking the weighted average cost of each capital component consisting of debt, equity, common stock, and preferred stock.

In financial decision-making, the most important factor is the financial metric. And it calculates the minimum needed rate of return for shareholders then they invest in the company based on the value of the investment. So that company must earn a minimum rate of return on its investment.

**The formula for Weighted Average Cost of Capital :**

**WACC = (E/V x Re) + (D/V x Rd x (1â€Šâ€”â€ŠT))**

**E** refers to the market value of equity.

**D** refers to the market value of Debt.

**Re** refers to the cost of equity which will be representing the rate of return and is needed by shareholders.

**Rd** refers to the cost of debt and it is representing the interest rate and the company paid interest for its outstanding debt.

**T** refers to the corporate tax rate.

How is WACC the most important factor in financial decision-making?

There are several reasons for WACC is an important financial metric in decision-making.

- WACC is used to determine the net present value NPV for the companyâ€™s future funds. when you think to make new investments in a company, WACC can be used as a discount rate. And this will be used to decide whether the companyâ€™s return is higher than the cost of capital. So you can consider WACC while taking financial decisions.
- WACC is used to take capital structure decisions which means it can be used to evaluate the cost of capital such as equity, debt, preferred stock, and common stock. Through this evaluation, the company can increase the value of an investment for its shareholders. At the same time, it can minimize the cost of capital. So WACC is used to determine the optimum capital structure for the company.
- A company has several business units. WACC is used to evaluate the performance of the business units and act as a benchmark in the company. If the companyâ€™s business unit produces a return higher than WACC then it creates higher value for the company. Otherwise, if the business unitâ€™s return is lower than the WACC then it would damage the value of the company.
- For valuing companies, WACC is used in discounted cash flow analysis which is used to estimate the present value of target companies’ future cash flow. And it is also used to calculate the intrinsic value of a companyâ€™s stock.

So the weighted average cost of capital generally denoted the important financial metric tool which is used to estimate the states of the minimum rate of return. A company must earn a minimum return to satisfy its investors and shareholders.

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## Components of Weighted Average Cost of Capital

The weighted average cost of capital is the cost of all capital sources and itâ€™s weighted represented the relative proportion of each source. For example, if the company has 20 million equity then the weight of equity would be 20%. And if the company has 20 million in debt then the weight of the debt would be 20%. To determine its contribution to the overall weighted average cost of capital, the cost of each capital source is multiplied by its weight.

**Also Read:** Understanding the Last Traded Price: A Beginnerâ€™s Guide

Do you know how to calculate the Weighted Average Cost of Capital?

## Calculation of weighted average cost of capital

The weighted average cost of capital calculates the different types of money involved in the company such as equity, debt, preferred stock, and common stock. The components of WACC are as follows:

### 1. Cost of equity:

For investing in a companyâ€™s stock, investors will need a return. This return refers to the cost of equity. The Capital Asset Pricing Model (CAPM) is used to estimate the cost of equity and investors can be used other models that consider the overall market risk and the companyâ€™s risk.

### 2. Cost of debt:

A company will pay its outstanding debt at an interest rate. so that interest rate refers to the cost of debt. Do you know how to estimate the cost of debt of a company? by calculating the interest rate of the existing debt of the company or by calculating the interest rate that the company will have to pay we can estimate the cost of debt of the company.

### 3. Weight of equity:

It refers to the percentage of the companyâ€™s capital financed by the companyâ€™s equity. The weight of equity is calculated by dividing the companyâ€™s outstanding equity by the total market value of the company.

### 4. Weight of debt:

It refers to the percentage of the companyâ€™s capital financed by the debt. The weight of debt is calculated by dividing the companyâ€™s outstanding debt by the total market value of the company.

### 5. Tax rate:

It refers to the percentage of the companyâ€™s income that will be paid to tax. A company pays the interest on its debt is tax deductible. And it can reduce the overall cost of the debt.

To calculate WACC, the cost of each component is multiplied by its weight. The sum of the multiplied values is WACC. The formula of WACC is as follows,

**WACC = (E/V x Re) + (D/V x Rd x (1â€Šâ€”â€ŠT))**

(or)

**WACC = (Weight of Equity x Cost of Equity) + (Weight of Debt x Cost of Debt x (1â€Šâ€”â€ŠTax Rate))**

In Financial Analysis, WACC is an important tool for estimating the minimum rate of return. when investors need to value the company for investment purposes, they can use the WACC calculation.

## Factors that Affect WACC

**The weighted average cost of capital** is the weighted average cost of different types of capital sources and it will be financing its company operation. Letâ€™s see what factors that affect WACC;

- A company has the structure of the capital source and it includes mixes of equity and debt. This equity and debt create a significant impact on WACC. When a company has high debt, WACC is also high. Because debt is more expensive than equity. So the structure of the capital source can affect WACC.
- The cost of debt is one of the important factors to affect WACC. A company pays interest rates on its outstanding debt. when an interest rate is high then the cost of debt is also high, and the WACC is also high.
- For determining WACC, the cost of equity is also an important factor affecting WACC. An investor expects to receive a higher rate of return from their investing. If a company has a higher rate of return then the cost of equity is high, and the WACC is high.
- A company pays the tax rate, which creates an impact on WACC. And the companyâ€™s interest payment on its outstanding debt which has tax-deductible. It will reduce the cost of debt.
- We assume, if the company has a riskier profile then the investors may demand a higher rate of return to compensate for that risk profile. So the companyâ€™s risk profile is one of the critical factors in WACC.
- Market conditions, inflation, and interest rates can create an impact on WACC. And it will affect the cost of equity and cost of debt.
- The industryâ€™s regulatory requirements, market dynamics, and competitive pressures can affect the overall WACC.

When determining the weighted average cost of capital, it is essential to analyze various factors that affect WACC.

## Limitations of WACC

The weighted average cost of capital is a useful financial metric tool. However, it has some limitations. Letâ€™s see what are the limitations of WACC as follows;

- The constant risk profile of a company, consistent tax rate, and stability of interest rate may have some assumptions. So these assumptions can lead to affect the accuracy of the WACC estimation.
- WACC includes the cost of equity, the cost of debts, and other weighted capital sources. From the analystâ€™s point of view, these componentsâ€™ values may differ from the company’s. So based on the analyst perspective, the estimation of WACC can differ.
- For a company that could diversify its capital sources such as bonds or hybrid instruments, the calculation of WACC is complex for them. There is less chance to determine accurate WACC estimation.
- For small and private companies have complexities to use this WACC financial metric tool. Instead of this WACC tool, they can use alternative methods for calculating the cost of capital.

## Conclusion

The weighted average cost of capital is an important tool for estimating the rate of return but it has some limitations. Despite limitations, the weighted average cost of capital remains a valuable tool for making financial decisions.