## Weighted Average Cost of Capital WACC: Definition and Formula

In other words, if the S&P were to drop by 5%, a company with a beta of 2 would expect to see a 10% drop in its stock price because of its high sensitivity to market fluctuations. The risk-free rate should reflect the yield of a default-free government bond of equivalent maturity to the duration of each cash flow being discounted. The capital asset pricing model (CAPM) is a framework for quantifying cost of equity.

For instance, WACC can be used as the discount rate for estimating the net present value of a project or acquisition. The after-tax cost of debt is included in the calculation of the cost of capital of a business. We have illustrated the WACC formula only for a project offering perpetual cash flows. But the formula works for any cash-flow pattern as long as the firm adjusts its borrowing to maintain a constant debt ratio over time. When the firm departs from this borrowing policy, WACC is only approximately correct. If project NPV is exactly zero, the return to equity investors must exactly equal the cost of equity, 12.5%.

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The formula to calculate the pre-tax cost of debt, or “effective interest rate,” is as follows. Conceptually, the cost of debt can be thought of as the effective interest rate that a company must pay on its long-term financial obligations, assuming the debt issuance occurs at present. Of course, quantifying the risk of an investment (and potential return) is a subjective measure specific to an investor.

The cost of capital measures the cost that a business incurs to finance its operations. It measures the cost of borrowing money from creditors, or raising it from investors through equity financing, compared to the expected returns on an investment. This metric is important in determining if capital is being deployed effectively. Third, even if the firm were willing and able to lever up to 90% debt, its cost of capital would not decline to 7.2%, as Q’s naive calculation predicts. You cannot increase the debt ratio without creating financial risk for stockholders and thereby increasing rE, the expected rate of return they demand from the firm’s common stock. The cost of equity is an implied cost or an opportunity cost of capital.

• CAPM takes into account the riskiness of an investment relative to the market.
• In practice, an internal rate of return is a valuation metric in which the net present value (NPR) of a stream of cash flows is equal to zero.
• Making matters worse is that as a practical matter, no beta is available for private companies because there are no observable share prices.
• The capital asset pricing model (CAPM) implies the expected rate of return on a security is a function of the underlying security’s sensitivity to systematic risk, which refers to the non-diversifiable component of risk.

The weighted average cost of capital (WACC) is the blended required rate of return, representative of all stakeholders. The starting point to compute a company’s weighted average cost of capital (WACC) is the cost of debt (kd) component. Conceptually, the cost of capital estimates the expected rate of return given the risk profile of an investment. The cost of capital, often referred to as the “discount rate,” is a central piece to analyzing a potential investment opportunity and performing a cash-flow-based valuation. Fundamentally, the cost of capital reflects the opportunity cost to investors, such as debt lenders and equity shareholders, at which the implied return is deemed sufficient given the risk attributable to an investment.

## Is Your Idea Worth the Investment?

Different tax rates for gains and losses tell us that before-tax and after-tax profitability may vary widely for these investors. These investors will forego investments with higher before-tax returns in favor of investments with lower before tax returns if lower applicable tax rates result in higher after-tax returns. For this reason, investors in the highest tax brackets often prefer investments like municipal or corporate bonds or stocks that are taxed at no or lower capital tax rates. The cost of this capital is an important ingredient in both investment decision making by the company’s management and the valuation of the company by investors. Therefore, the estimation of the cost of capital is a central issue in corporate financial management and for an analyst seeking to evaluate a company’s investment program and its competitive position. The cost of equity is the return an investor demands for their holding of shares of the company.

Ultimately, the decision to proceed with the investment would be perceived as irrational from a pure risk perspective. In short, a rationale investor should not invest in a given asset if there is a comparable asset with a more attractive proprietary ratio explanation formula example and interpretation risk-reward profile. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance.

## What is WACC?

Several factors can increase the cost of debt, depending on the level of risk to the lender. These include a longer payback period, since the longer a loan is outstanding, the greater the effects of the time value of money and opportunity costs. The riskier the borrower is, the greater the cost of debt since there is a higher chance that the debt will default and the lender will not be repaid in full or in part. Backing a loan with collateral lowers the cost of debt, while unsecured debts will have higher costs.