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What is WACC?

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Used in a sentence

The Daily Ledger · Markets

The memo rejected the proposal outright, since a 9% return sat well below the group's WACC.

The reader highlighted one word mid-article. Clicked explained the finance term “WACC” in plain language:

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Overview

WACC is the average rate a company pays for the money it uses, counting both borrowed money and money supplied by shareholders. Lenders charge a stated interest rate. Shareholders are paid no stated rate, but they expect a return and move their money elsewhere without one, so that expectation is a real cost. Weight the two rates by how much each provides and the result is a single percentage. A project earning less than that leaves the company worse off.
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Overview

WACC is what a company's money costs, averaged across everyone who supplied it. Lenders are the easy half, since the rate sits in the loan document. Shareholders are the half people forget: no invoice, no payment date, so their money feels like the free stuff. It is the expensive half. They are last in line if the company fails, so the return they expect for that risk runs above anything a lender would settle for, and that expectation is the cost. 😎

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Detail

WACC stands for weighted average cost of capital, and it answers one question: what does this company's money cost? Funding arrives from two places. Borrowed money carries an interest rate, usually written into the loan. Money from shareholders carries no invoice, which is why its cost is often missed, but those shareholders could have put the same money elsewhere and they expect a return for choosing not to. Each rate is weighted by its share of the total funding, and the two are added. Debt is the cheaper half for two reasons: lenders are repaid before owners if the company fails, so they accept less, and interest reduces the tax bill, which lowers the true cost again. That does not make more debt always better, because every additional loan raises the chance of a missed payment, so lenders and shareholders both begin expecting more. WACC is used as a threshold, and many companies set their hurdle rate directly from it. A project forecast to return 9% inside a company whose money costs 11% destroys value, however healthy the accounting profit looks. It is also the rate used to discount future cash flows when a company is valued, which makes it one of the few figures shaping both which projects get approved and what the whole business is judged to be worth.
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Detail

WACC is the blended price of a company's money, part borrowed and part handed over by shareholders, averaged by how much each of them supplied. Lenders are the straightforward half, because the rate is written in the loan. Shareholders are the half everyone forgets. Nobody invoices you for their money, no payment date exists, nothing bounces if you ignore them, so it feels like the free stuff. It is the expensive stuff. They are last in the queue if the company goes under, so the return they expect for carrying that risk runs well above anything a bank would accept, and that expected return is the cost. Run the numbers: sixty per cent borrowed at 5%, forty per cent from owners expecting 12%, and the company's money costs about 8%. Every proposal now has an 8% bar. Here is where people go wrong. Debt is the cheap half and the interest cuts your tax bill, so loading up on it looks like a free upgrade. It works up to a point. Past that point lenders want more for the extra risk, shareholders expect more for the same reason, and the cost of the company's capital goes up. The cheap money stopped being cheap precisely because you took so much of it. 😎

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Analogy

A skipper needs $100,000 for a fishing boat. The bank lends $60,000 at 6%, and that payment falls due whether the season is good or bad. A partner supplies the other $40,000 and is owed nothing at all. She takes a share of whatever the catch sells for, so in a poor season she receives nothing while the bank is still paid in full. For carrying that risk she needs the boat to return around 15% on average, otherwise she would put her money somewhere safer. Sixty per cent of the funding costs 6% and forty per cent costs 15%, so the boat has to earn about 9.6% overall before both backers are satisfied. That blended figure is the WACC.
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Analogy

You need $10,000 of kit to start a wedding photography business. The bank lends you $5,000 at 8%, and that payment lands every month whether or not anybody gets married. A friend puts in the other $5,000 and takes a cut of the bookings instead, so in a quiet year she gets nothing. She is not doing that for 8%. She wants something nearer 18%, because she is the one absorbing the quiet years. Your money costs about 13% blended, and nobody sends you a bill for the expensive half. 😎
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Formal definition — The same term, explained the usual way

WACC, the weighted average cost of capital, is the mean required return on a firm's invested capital, computed by weighting the after-tax cost of debt and the cost of equity by their respective proportions of total capital measured at market value. The cost of equity is not directly observable and is customarily estimated, most commonly through the capital asset pricing model. WACC serves as the standard discount rate in discounted cash flow valuation and as the reference threshold in capital budgeting, subject to the condition that the project under assessment carries risk comparable to that of the firm's existing operations.

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