1st Nov 2009 by Amelia Timbers
WACC is a term used in finance to refer to capital structure- the balance of capital within a firm. WACC stands for “Weighted Average Cost of Capitol”. Publicly traded companies are financed by debt (loans) and equity (private investment from some source- shareholders, venture capital, etc). Firms strive to strike a balance between how much debt vs. equity to use in order to maximize their stock’s value. WACC is a figure that describes the ideal balance of debt and equity, often called a target, or optimal, capital structure.
Companies calculate their WACC by multiplying the proportion of debt times the interest rate of the debt, plus the proportion of equity times the cost of equity. The cost of equity can be calculated using the CAPM model, and the cost of debt is the rate of outstanding loans (may be averaged).
WACC= (% of firm’s financing that is debt)(after tax cost of debt) + (% of firm;s financing that is equity)(cost of equity).
If a firm has preferred stock, the percentage of preferred stock and rate of preferred stock must be added in as a third term.
A company’s WACC is the figure that management uses as a threshold rate of return for new projects. For example, if a company calculates their WACC to be 8%, then they should only make new capital investments that are forecast to return 8% or more. The reasoning behind this is that new investment must make back at least the cost of the capital to finance it.
WACC is not an exact figure. Like many financial models, the inputs greatly affect the outcome. WACC is also a tool that can help investors assess a company. A company with a very high or low WACC for its sector should alarm an investor and inspire more research.
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