Weighted Average Cost of Capital
The weighted average cost of capital (WACC) is the rate a company is expected to pay, on average, to its security holders. The WACC is also the benchmark rate, or the minimum rate of return, a company must earn on a new venture in order to make the investment worthwhile. Stated differently, the return on capital of a new project must be greater than the weighted average cost of capital.
Different securities, which represent different sources of finance, are expected to generate different returns. Since companies raise money using any number and combination of these sources - i.e. debt, common stock, preferred stock, retained earnings - it is important to calculate the cost of capital taking into account the relative weights of each component of a company's capital structure.
In order to calculate WACC, a few inputs must be known, namely, the cost of debt, the cost of equity, and the company's marginal tax rate.
As the above equation states, the cost of debt, rD(1 - T), is multiplied by the ratio of debt to total market value of the company. This is then added to the cost of equity, rE , multiplied by the ratio of equity to total market value. The costs of debt and equity incorporate the individual costs of each form of debt and equity, such as common stock, preferred stock, retained earnings, and different types of bonds. Because there are many possible methods of estimating each element, calculating the WACC can be complex and problematic and can return a wide range of values.