what is weighted average cost of capital?
What is Weighted Average Cost of Capital (WACC) and Why Should You Care?
Alright, let’s talk about something that sounds super technical but is actually pretty straightforward: Weighted Average Cost of Capital (WACC). If you’ve ever wondered how businesses figure out the cost of funding their operations, this is it.
Breaking It Down: The Cost of Money
Imagine you’re starting a sneaker reselling business. To get things rolling, you need cash—maybe you take out a loan from your parents (debt) and pitch your idea to a friend in exchange for some of your future profits (equity). Each source of money has a cost: your parents want their loan repaid with interest, and your friend expects a share of your earnings.
WACC works the same way for big companies. They raise money through a mix of debt (loans/bonds) and equity (selling shares to investors). Since each type of funding has a cost (interest for debt and expected returns for equity), WACC calculates the average cost of all that capital, weighted by how much of each they use.
The Formula (Without Making Your Head Hurt)
The actual formula is:
WACC=(E/V)×Re+(D/V)×Rd×(1−Tc)
Where:
E = Market value of equity (stocks)
D = Market value of debt (loans/bonds)
V = Total value (E + D)
Re = Cost of equity (what investors expect to make)
Rd = Cost of debt (interest rates on loans)
Tc = Corporate tax rate (because debt interest is tax-deductible)
Why WACC Matters
Investment Decisions: Companies use WACC to decide if a project is worth it. If a new factory’s expected return is higher than WACC, they go for it. If it’s lower, it’s not worth the cost.
Stock Valuation: Investors check if a company is making enough returns to justify its WACC. If not, it might not be a great investment.
Risk Indicator: A high WACC means a company is seen as riskier (maybe they rely on expensive loans), while a low WACC suggests they have cheaper, stable financing.
How WACC Connects to DCF (Discounted Cash Flow)
Now, if you’ve heard of Discounted Cash Flow (DCF) analysis, WACC is a key ingredient in that formula.
DCF is one of the most common ways investors figure out how much a company (or investment) is really worth. It works by estimating all the cash a company will make in the future and then discounting those future cash flows back to today’s value—because $1 today is worth more than $1 five years from now.
And what do you use as the discount rate in a DCF? WACC.
DCF in Simple Terms
Think about it like this:
You’re buying a vending machine that will make you $2,000 a year for 10 years.
But you know money loses value over time (inflation, risk, opportunity cost).
So you need to figure out what those future cash flows are actually worth in today’s dollars.
To do that, you discount them using WACC, which adjusts for the company’s cost of capital.
Why This Matters for Investors
If the present value of future cash flows (calculated using DCF) is higher than the company’s current stock price, the stock is undervalued, and it might be a good buy. If it’s lower, the stock is likely overvalued.
The Teenagetraders Takeaway
WACC isn’t just a corporate finance term—it’s basically the price of money for a company. And if you want to find a stock’s true value using DCF, WACC is your go-to discount rate.
So next time you hear about a company’s valuation, ask yourself: is their expected return actually higher than their cost of capital? If not, they’re burning cash, not making it.
Now, what’s a stock you own (or are watching) and what do you think its WACC looks like? Let’s discuss! 🚀💰
