Weighted Average Cost of Capital (WACC)
What it is:
How it works (Example):
Here is the basic formula for weighted average:
A company is typically financed using a combination of debt (bonds) and equity (stocks). Because a company may receive more funding from one source than another, we calculate a weighted average to find out how expensive it is for a company to raise the funds needed to buy buildings, equipment, and inventory.
Let's look at an example:
Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000 shares of stock at $100 each to raise the first $600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.
Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital. The people who bought those bonds expect a 5% return, so ABC's cost of debt is 5%.
Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) = $1 million and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation ABC's weighted average cost of capital (WACC).
x .06) + [(($400,000/$1,000,000) x .05) * (1-0.35))] = 0.049 = 4.9%
Corporation ABC's weighted average is 4.9%.
This means for every $1 Corporation ABC raises from investors, it must pay its investors almost $0.05 in return.
Why it Matters:
A company looking to lower itsCorporation ABC may issue more bonds instead of stock because it can get the financing more cheaply. Because this would increase the proportion of debt to equity, and because the debt is cheaper than the equity, the company's weighted average would decrease.may decide to increase its use of cheaper financing sources. For instance,