A:

Weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds and any other long-term debt. It is calculated by multiplying the cost of each capital source by its relevant weight, and then adding the products together to determine the WACC value.

Internal and external factors can cause problems for investors and analysts trying to assess the performance of a firm over time and in comparison with other firms in the industry. One external factor is the fluctuation of interest rates. The Federal Reserve Bank (the Fed) moderates long-term interest rates by targeting the federal funds rate - the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank overnight.

The Fed attempts to align the effective federal funds rate with the targeted rate by making additions to or subtractions from the money supply through open market operations (the buying and selling of U.S government securities, or Treasury bills).

As interest rates are moderated, it can cause fluctuations in the risk-free rate, the theoretical rate of return for an investment that has no risk of financial loss. This can affect a firm's WACC because the risk-free rate is an important factor in calculating the cost of capital. As the interest rate on debt fluctuates, it can be challenging for a company to predict the future costs of capital. As a result, a company can end up with greater or lesser capital costs than expected because of fluctuations in interest rates. A firm's cost of debt must be updated frequently as the cost of debt reacts to fluctuations in interest rates.

Other external factors that can affect WACC include corporate tax rates, economic conditions, and market conditions.

RELATED FAQS

  1. How does additional paid in capital affect retained earnings?

    Find out how additional paid-in capital can impact a company's retained earnings, including an explanation of both financial ...
  2. How can EV/EBITDA be used in conjunction with the P/E ratio?

    Learn how traders and analysts use the two equity evaluation metrics, EV/EBITDA and P/E, together to obtain a more complete ...
  3. How can a company reduce the unsystematic risk of its own security issues?

    Understand the basic concepts of systematic and unsystematic risk, and learn steps a company can take to reduce its level ...
  4. How can I find net margin by looking a company's financial statements?

    Learn how to calculate a company's net margin using financial statements by dividing the company's net revenues by its net ...
RELATED TERMS
  1. Weighted Average Cost Of Capital - WACC

    A calculation of a firm's cost of capital in which each category ...
  2. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative ...
  3. Nonadmitted Balance

    An item on an insurer’s balance sheet that represents reinsured ...
  4. Best's Capital Adequacy Relativity (BCAR)

    A rating of an insurance company’s balance sheet strength. Best’s ...
  5. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  6. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...

You May Also Like

Related Articles
  1. Investing

    Weighted Average Cost Of Capital (WACC)

  2. Investing Basics

    Useful Balance Sheet Metrics

  3. Fundamental Analysis

    Understanding The Federal Reserve Balance ...

  4. Bonds & Fixed Income

    Investors Need A Good WACC

  5. Term

    Weighted Average Cost Of Capital - WACC

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!