What Does Weighted Average Cost of Capital (WACC) Mean?
The weighted average cost of capital represents a weighted average of the after-tax cost of debt and the cost of equity where the weighting is based on a company’s target debt-equity ratio, measured at market. Here is how each component of a WACC can be measured:
An optimal capital structure of equity and debt can be obtained from an analysis of comparable public company capital structures.
The cost of debt is relatively simple to determine by comparing the current market rate of interest paid on similar debt instruments.
The cost of equity is more difficult to calculate. Methods such as the CAPM or the buildup approach are common used to calculate the cost of equity.
Divestopedia Explains Weighted Average Cost of Capital (WACC)
The weighed average cost of capital is an important concept to understand for private business owners. Finding ways to reduce the WACC can boost returns on shareholders' equity. Many business owners are debt averse, but the optimal amount of debt will lower the WACC without significantly increasing the risk of default. Of course, it is important to determine an appropriate amount debt where free cash flow is more than enough to meet debt repayment obligations.
Sophisticated strategic and financial buyers will compare the WACC in a target firm to their expected return on capital. Many times, these buyers can buy a company and optimize its inefficient capital structure to drive higher returns.
The WACC is also one of the most subjective variables used in the discounted cash flow valuation approach. A variation as small as one percentage point can have a huge variance in the resulting value conclusion. When selling a company, it is important to provide support and justification for the appropriate WACC used in the discounted cash flow valuation.