WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Back to GlossaryDefinition
—the blended cost of a firm’s equity and debt, used as a discount rate.
Summary
The Weighted Average Cost of Capital (WACC) is a financial metric that represents the average rate a company must pay to finance its assets through a combination of debt and equity. It's calculated by weighing the cost of each source of capital (debt and equity) by its proportion in the company's capital structure. WACC serves as a hurdle rate for investment decisions - projects must generate returns above the WACC to create value for shareholders. Think of it as the company's 'borrowing rate' that accounts for both the interest paid on debt and the returns expected by equity investors.
Usage Context
WACC is crucial when learning capital budgeting, company valuation, capital structure decisions, and investment analysis. It's essential for NPV calculations, determining whether projects create shareholder value, and understanding how financing decisions impact firm value. Students encounter WACC in corporate finance when analyzing investment opportunities and making strategic financial decisions.
Common Confusions
- Using book values instead of market values for debt and equity weights
- Forgetting to use after-tax cost of debt due to tax deductibility of interest
- Confusing WACC with required rate of return for individual projects
- Thinking WACC is constant - it actually changes with capital structure and market conditions
- Mixing up cost of equity with dividend yield
- Assuming WACC applies to all projects regardless of risk level
