Weighted Average Cost

Introduction to the

The main objective of this is to provide an overview of weighted average cost of capital , that is , how it is computed and interpreted for any company . The weighted average cost of capital is an important aspect for any company to compute and interpret the rate of return that they earn for every dollar that they pay

Introduction to Weighted Average Cost of Capital

The weighted average cost of capital is calculated in to analyze the amount of cost that they will need to pay for the next dollar

that the company borrows . This is an important cost to consider even when considering or deciding between different projects to be undertaken

Every company is financed by either equity or debt . This means that the weighted average cost of capital would consist of all kinds of debt as well as all types of equity . There are two kinds of equity that are common in companies are and common stock which must be weighed separately

The weighted average cost of capital is considered to be an average of the costs of debt and equity according to their proportions so that the company can understand how much of cost is being taken in and by which component . The weighted average cost of capital shows a clear division of the weight that is allotted to debt and then to equity . By taking a weighted average , we can see how much interest the company has to pay for every dollar it finances (Investopedia , 2007

The weighted average cost of capital , as mentioned above , is also used for evaluating potential projects that can be taken up by the company However , in to evaluate the projects , there is a need for a discount rate that is used for finding the net present value of the cash flows that are expected to be received from the project

The discount rate for the project is then evaluated from the weighted average cost of capital . A firm 's WACC is the overall required return on the firm as a whole and , as such , it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers (Investopedia , 2007

Calculating the Weighted Average Cost of Capital

The weighted average cost of capital is simply calculated by the following formula provided

WACC wd (1-T ) rd we re

Where wd and we are the weights that are allotted to the proportion of debt and equity respectively in the company (1-T ) is the tax shield component that is saved from the net income of the company by deducting the interest before tax . This means that when interest to be paid on debt is deducted from operating income before tax , this causes the company to have less taxable income and hence , pay fewer taxes to the government

rd and re are the costs of each debt and equity that are then multiplied with their individual and respective weights in to give...