WACC (weighted average cost of capital)
The weighted average cost of capital: the minimum return the company must deliver to its investors and lenders.
WACC, or weighted average cost of capital, is a calculation showing the average cost of financing a business with both debt and equity. It takes into account the relative weight of each source of financing and gives an insight into the minimum return the business must achieve in order to satisfy investors and lenders.
How it is calculated
WACC is calculated by multiplying the cost of equity by the weight of equity, adding the cost of debt capital multiplied by the weight of debt capital, and then summing these values. The formula is as follows:
WACC = (Cost of equity × Weight of equity) + (Cost of debt capital × Weight of debt capital)
The weights depend on the proportion of equity and debt capital in the company's capital structure.
What is WACC used for?
WACC is an important tool for assessing the profitability and the risk connected with an investment or a project. It is often used as the discount rate for calculating the present value of future cash flows. WACC takes into account the costs of both debt and equity, and therefore reflects the return investors and lenders require in order to invest in the business.
Tips for reducing WACC
- Optimise the capital structure. Consider optimising the mix of debt and equity in order to reduce the total cost of capital. This may involve refinancing debt at a lower rate of interest, or issuing equity in order to reduce the debt-to-equity ratio.
- Reduce the cost of capital. Explore opportunities to lower the costs of equity and debt. For example, negotiations with lenders and investors may lead to more favourable terms or lower interest rates.
- Improve the business's risk profile. Reduce the business's risk through diversification, the implementation of governance systems and risk management measures. This can help reduce the total cost of capital.
- Optimise tax planning. Explore opportunities to make use of tax reliefs or reduce the tax liability, since this can affect the effective cost of capital.
- Continuous monitoring. WACC can change over time because of changes in the capital structure, in interest rates and in investors' expectations. Make sure to monitor and adjust WACC regularly so that it reflects reality.
More terms in returns and investment analysis
See all →ROE (return on equity)
Measures the return a business generates on the equity its shareholders have invested.
ROA (return on assets)
Shows how efficiently a business uses its total assets to generate profit.
ROCE (return on capital employed)
Measures the return on all capital in the company, both debt and equity.
ROI (return on investment)
Measures the profitability of an investment relative to what it cost.
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