The weighted normal expense of capital (WACC) is the rate that an organization is relied upon to pay by and large to all its security holders to fund its advantages. The WACC is usually alluded to as the association’s expense of capital. Significantly, it is not directed by administration. Or maybe, it speaks to the base give back that an organization must gain on a current resource base to fulfill its banks, proprietors, and different suppliers of capital, or they will contribute somewhere else.
Companies raise money from a number of sources: common stock, preferred stock, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company’s capital structure, the more laborious it is to calculate the WACC.
Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.
In general, the WACC can be calculated with the following formula:
where N is the number of sources of capital (securities, types of liabilities); r_i is the required rate of return for security i; and MV_i is the market value of all outstanding securities i.
In the case where the company is financed with only equity and debt, the average cost of capital is computed as follows:
where D is the total debt, E is the total shareholder’s equity, Ke is the cost of equity, and Kd is the cost of debt. The market values of debt and equity should be used when computing the weights in the WACC formula.
Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of MV_e and cost of equity R_e and one type of bonds with the total market value of MV_d and cost of debt R_d, in a country with corporate tax rate t, is calculated as:
Actually carrying out this calculation has a problem. There are many plausible proxies for each element. As a result, a fairly wide range of values for the WACC for a given firm in a given year, may appear defensible.