Weighted Average Cost of Capital WACC

What is the Weighted Average Cost of Capital?

The weighted average cost of capital assignes a weight proportional to the firms capital structure. That is, a percentage of each type of capital owned by the firm. For example, if the firm has $250 in bonds, $250 in preferred stock, and $500 in common stock, the weights would by .25, .25, and .50 respectively. This allows the firm to establish a benchmark as to what discount or rate of return is neccessary to cover both debt and equity required rates of return. Sometimes companies will use exact dollar figures to caculate these weights; however, many companies simply use the percentages as weights.

The components of WACC are both debt and equity financing. It is calculated by multiplying the after-tax cost of debt times the proportion of debt financing plus the cost of equity times the proportion of equity financing. The reason the WACC is more appropriate for capital budgeting is because, as stated previously, it gives the firm an idea of the amount or discount rate require to satisfy the required rate of return on both debt and equity securities held by lenders and shareholders.

When a organization needs to raise long-term capital, oftentimes this capital will be mixed with other sources of capital. Therefore, calculating the NPV using the correct discount rate may be difficult. However, WACC makes possible such calculations, especially when dollar amounts are used as opposed to percentages.