Weighted average cost of capital is the amount a company pays for its capital, on average, based on all of its funding sources. Capital can come from stock, bonds or debt. Each of these sources has a cost. The weighted average cost of capital (WACC)calculation reflects the cost of each type of capital in proportion.
How much a company has to pay to finance its business is reflected in the weighted average cost. It shows how much of a return on investment the company must get in order to finance its debt and its equity. If a company is planning to expand or to begin a new project, or is considering a merger or an acquisition, it will look at the projected return and compare it to the weighted average cost of capital to determine if the plan is feasible.
The average weighted cost of capital can be used to assess the risk of a company overall, or of a particular project or venture. A higher weighted average cost of capital represents a higher risk, simply because the project must return more money in order to break even. Two or more options can be compared by comparing the weighted average costs of capital for the various options.
In order to calculate the weighted average cost of capital, several factors must be known. The number of different types of capital, such as stock, bonds, debt and other liabilities; the required rate of return on each type and the market value of each of the types of securities are all taken into account when calculating the weighted average cost of capital. For large companies with many sources of capital, this calculation can get quite complex. Some of the information required can be found on the company’s financial statements, but other factors, such as the market value of the securities, will have to be researched.
In addition to providing information on a particular company or project, the weighted average cost of capital can be calculated for a given industry as a whole. By comparing the industry cost to that of a company or a project, an investor can determine the level of risk that the company has, or will incur by undertaking the new project. The WACC for a new project or merger may be different from the company’s existing WACC if the project or merger is deemed more or less risky that the company’s present position.