Wacc

Weighted average cost of capital (WACC) is the calculation used to proportionally weigh each category of capital. This calculation includes all sources of capital such as common stock, preferred stock, bonds and other long-term debt. WACC is calculated using the following formula:

WACC= (E/V) * Re + (D/V) * Rd * (1-Tc)

Here Re is the cost of equity, Rd is the cost of debt, E is the market value of the firms’ equity, D is the market value of the firms’ debt, V is the summation of the market value of the firms equity and debt and Tc is the corporate tax rate. By separately dividing the firms market value of equity and debt by V the percentages of financing the equity and debt is given. All together the firm is then given a percentage which represents the overall required return on the firm as a whole. (Investopedia)

To better understand WACC and how it works companies must remember the basics of financing.

• Capital of any company has two components, debt and equity.

• Return on funds is expected by shareholders and lenders.

• Cost of capital is the expected return to equity owners and debtholders.

Keeping this in mind companies can use WACC to see the return that can be expected, therefore, WACC is the opportunity cost of taking on the risk of putting money into a company. (Investopedia).

WACC can have several meanings/uses and the correct data must be collected. For instance it also is an expression of the cost of the value for shareholders that companies give by earning a return on the invested capital. Therefore this formula can be used to see if the investment the company is making is worthwhile. (Value Based Management). WACC helps companies see “the minimum return that must be earned on current assets in order to satisfy owners, investors and other providers of capital.” (Wikipedia).For this formula to be effective market values must be used. Market values are used instead of book values because WACC measure the expected cost of new...