WACC

WACC stands for the weighted average cost of capital. It represents the rate of return a company must make on the money it has invested to stop investors putting their money elsewhere. In short, it is the company’s cost of money.

To calculate it, you take the weighted average of the cost of borrowing money from banks or bondholders (debt) and shareholders (equity). The cost of debt is the interest rate charged by borrowers, less the company’s tax rate (because interest charges reduce a company’s taxable profits).

However, equity costs more than debt, because shareholders get paid last and so need to be paid more to reflect this. Exactly how much extra is subject to a lot of debate, and there is no right answer. It is affected both by how risky the underlying business  is and how indebted it is.

Say a business is half-funded by debt at 5% and half-funded by equity at 10%. Its WACC will be (0.5×5%) + (0.5×10%) = 7.5%. WACC can be a better way to measure the ability of company managers than earnings per share (EPS). When interest rates are low, managers can boost EPS by funding the company with more debt, but may not earn a high enough return to compensate shareholders for the risks

Merryn

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