Weighted Average Cost of Capital

Weighted average cost of capital (WACC) is defined as the amount that a company or a firm would pay for its capital, on average, based on all of its funding sources. The weighted average cost of capital represents an average expected return on all of a company's securities. It refers to the calculation of a firm's cost of capital in which each category of capital is proportionately weighted.

In the calculation of WACC includes all capital sources like the common stock, preferred stock, bonds and any other long-term debt. When all the factors are equal the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk.

There are a number of factors considered in the calculation of WACC. Firstly all the types of securities, 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 are considered in the calculation the weighted average cost of capital. When the larger firms have many sources of capital, this calculation can get quite complex. The information for sources on capital is extracted from the company’s financial statements, but other factors, such as the market value of the securities, will have to be researched.

The weighted average cost of capital is not calculated to individual projects of a company but for an industry as a whole. When the industry cost to that of a company or a project is compared, an investor can determine the level of risk that the company has, or will incur by undertaking the new project. Depending upon the company’s present position 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.

Questions:

• What is weighted average cost of capital?
• What are the various factors to be considered in the calculation of WACC?