Introduction to Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Capital (WACC) calculates the weighted average of the total cost that went and goes into acquiring capital. If there are more than one source of funds for the company or firm (as there usually are), WACC computes the total cost and its WA.
Understanding Weighted Average Cost of Capital (WACC)
WACC is a financial ratio, which accounts for the cost that the company is undertaking in order to fund an investment decision, so that the returns that come from the investment are greater than the costs. This is what cost of capital refers to— the assessment between amount of time and money (and effort, but it’s immeasurable) taken to justify the risk of the money borrowed to fund the investment decision. Cost of Capital can be explained like this: if you’re a manager trying to look for a proper instrument, you will choose to examine it and then accumulate funds to purchase it. But from where? A loan, or stock sales etc. The interest to be paid on such a loan will become the cost since it is the expense you will pay extra to get the loan. WACC will take that cost of all sources of funds from where you are accumulating your capital from and calculate the weighted average for it. The interpretation is positive and favourable when the WACC is lesser than the return that the investment has generated or can generate. Investors judge the financial decisions by taking WACC as one of their factors.
Highlights of Weighted Average Cost of Capital (WACC)
- WACC is widely used in Discounted Cash Flow Valuation (DCFV).
- Each category in the source of funds is proportionately weighed.
- Broadly speaking, WACC is a proportionally weighted average to determine whether the investment is worth the risk or not.
- WACC doesn’t vouch for the change in capital structure or take into consideration the changes in risk profile. Therefore, it makes sense to not base off all decisions on the basis of WACC alone.
