The Weighted-Average Cost of Capital

Abstract

This note provides a conceptual introduction to the weighted-average cost of capital (WACC). It discusses and provides examples of calculating the WACC and its components. It is useful as a parallel reading for cases that require estimation of WACC or as background reading for a class discussion of WACC and its use as a hurdle rate. Excerpt UVA-F-1185 Rev. Dec. 18, 2013 THE WEIGHTED-AVERAGE COST OF CAPITAL Most firms finance their assets with some combination of equity and debt. Figure 1 illustrates the situation. For many purposes, it is often useful to calculate an average of the equity and debt returns. In effect, we lump all suppliers of funds together and calculate a weighted-average cost of capital (WACC). This figure is thus the cost of raising funds given whatever mix of financing the firm has chosen. The same concept is sometimes referred to as the weighted-average required return, since investors' required returns are equivalent to the cost to the firm of raising capital. The WACC measures the rate of return investors require from a company, given the firm's existing business risk and financial strategy. As a result, the WACC is an important benchmark for financial performance. A firm creates value for investors only if its earned returns can exceed investors' requirements. Thus the WACC can be used as a required rate of return in evaluating a company's average risk-investment opportunities or to calculate capital charges for economic value-added calculations. If a firm can earn returns higher than its WACC on its average risk investments, it will create value for shareholders. One word of caution. A firm's WACC is based on the mix of its current businesses. If the firm were to move into much more risky ventures, then its current WACC would not reflect investors' reaction to the increased risk. One approach companies use to gauge a benchmark for such higher-risk pursuits is estimating a WACC for another company—one which is primarily in a riskier line of operations. . . .