What is WACC?
The Weighted Average Cost of Capital (WACC) represents the average rate that a business pays to finance its assets. It is calculated by taking a weighted average of the cost of both equity (investor capital) and debt (loans and bonds).
The WACC Formula
To accurately calculate WACC, financial analysts use the following mathematical equation:
$$WACC = \left(\frac{E}{V} \times Re\right) + \left(\frac{D}{V} \times Rd \times (1 - Tc)\right)$$
- E = Market value of the firm's equity
- D = Market value of the firm's debt
- V = Total value (E + D)
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate (creates a tax shield for debt)
Frequently Asked Questions
Is a lower or higher WACC better?
A lower WACC is generally preferred. A lower cost of capital means the company pays less to fund its growth, which translates to a higher overall business valuation.
Why is the tax rate included in the WACC formula?
Because interest payments on debt are tax-deductible. This deduction creates a "tax shield" that reduces the effective cost of borrowing, which is why the cost of debt is multiplied by (1 - Tax Rate).