# Weighted Average Cost of Capital (WACC) Explained with Formula and Example.

The weighted average cost of capital (WACC) is a financial metric that calculates the average cost of a company's capital, which includes both debt and equity. The WACC is used to discount a company's future cash flows in order to determine their present value.

The WACC formula is:

WACC = (E/V) x Re + (D/V) x Rd x (1-Tc)

Where:

E/V = the ratio of a company's equity to its total value
Re = the required return on equity
D/V = the ratio of a company's debt to its total value
Rd = the required return on debt
Tc = the corporate tax rate

The weighted average cost of capital is important because it is used in the discounting of a company's future cash flows. This is important because the discount rate is used to determine the present value of those cash flows.

The weighted average cost of capital can be used to make investment decisions. For example, if a company is considering two investment projects, it can use the WACC to discount the future cash flows of each project and compare the present values. The project with the higher present value is the more desirable investment.

It is important to note that the WACC is a long-term average. This means that it should not be used to make decisions about individual projects with shorter time horizons.

Example

Let's say that Company XYZ has a total capitalization of \$1,000,000. This includes \$500,000 of equity and \$500,000 of debt. The required return on equity is 10% and the required return on debt is 5%. The corporate tax rate is 35%.

Using the formula above, we can calculate the weighted average cost of capital for Company XYZ:

WACC = (E/V) x Re

### What is cost of capital explain the types of cost?

Cost of capital refers to the cost of funds used to finance a company's operations. It includes the costs of equity, debt, and preferred stock. The cost of equity is the return that shareholders expect from investing in a company. The cost of debt is the interest rate on loans and other debt instruments. The cost of preferred stock is the dividend rate paid to preferred shareholders.

There are several types of cost of capital. The weighted average cost of capital (WACC) is the average of the cost of equity and the cost of debt, weighted by their respective proportions of the company's total capital. The cost of new equity is the return that investors expect from investing in a company's new equity shares. The cost of retained earnings is the return that shareholders expect from investing in a company's existing equity. Finally, the cost of debt is the interest rate on loans and other debt instruments.

##### What affects WACC?

There are many factors that affect a company's WACC. Some of the more important ones are:

1) The company's debt-to-equity ratio: The higher the ratio, the higher the WACC, all else being equal.

2) The company's credit rating: The lower the rating, the higher the WACC.

3) The company's tax rate: The higher the tax rate, the higher the WACC.

4) The company's beta: The higher the beta, the higher the WACC.

5) The risk-free rate: The higher the risk-free rate, the higher the WACC.

6) The market risk premium: The higher the market risk premium, the higher the WACC.

What is cost of capital Example? The cost of capital is the minimum rate of return that a business must earn on its investments in order to generate value for its shareholders.

The cost of capital is calculated by taking the weighted average of the cost of each type of capital, which includes equity, debt, and preferred equity. The weights are determined by the proportion of each type of financing used by the company.

For example, if a company has \$1,000 in equity and \$500 in debt, the cost of equity would be weighted at 2/3, and the cost of debt would be weighted at 1/3.

The cost of capital is often used as a discount rate when evaluating investment opportunities.

Theoretically, a company should only invest in projects that have a return greater than the cost of capital.

In practice, however, companies often invest in projects with a lower return because they may not have any other good investment opportunities, or because they are trying to increase the value of the company by taking on more risk.

### What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt 20% on its equity and has a 40% tax rate?

The weighted average cost of capital (WACC) for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity, and has a 40% tax rate, would be 16%. This is calculated by taking the weighted average of the cost of each type of financing, after accounting for the tax shield on the debt. The cost of debt is 12% (0.12), the cost of equity is 20% (0.20), and the tax rate is 40% (0.40). The weighted average cost of capital would be 0.12 x (1 - 0.40) + 0.20 x 0.50 = 0.16, or 16%.

#### What is the difference between WACC and cost of capital?

The WACC is the weighted average cost of capital and is used to estimate the average annual cost of financing a company's assets. The cost of capital is the minimum return that a company must earn on its investments to satisfy its shareholders. The WACC is used to discount a company's future cash flows to their present value.

The cost of capital is the required rate of return on a new investment. The WACC is the required rate of return on the existing assets of a company. The cost of capital is used to discount future cash flows from a new investment. The WACC is used to discount future cash flows from the existing assets of a company.