The weighted average cost of capital (WACC) refers to the rate that a company is expected to pay on average to all its capital providers to finance its assets.
A company raises capital from various sources namely: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants,each category of capital is proportionately weighted. options, pension liabilities, executive stock options, governmental subsidies etc. While calculating WACC, each category of capital is proportionately weighted.
WACC is commonly used by companies internally to arrive at meaningful investment decisions. It is often used as a hurdle rate for capital investment. It also acts as a measure to find the optimal capital structure for the company and is a key factor in choosing the mixture of debt and equity used to finance a firm.
WACC is calculated by multiplying the cost of each source of capital for a project—which may include loans, bonds, equity, and preferred stock by its percentage of the total capital, and then adding them together.
WACC = D/(D + E) × 1/(1 - t) × i + E/(D + E) × r
where i is the interest rate,
r is the required return on equity,
D is the amount of debt capital
and E is the amount of equity capital.