A:

A high weighted average cost of capital, or WACC, is typically a signal of higher risk associated with a firm's operations. Investors tend to require additional return to assume additional risk.

Let's back up a bit. A company's WACC can be used to estimate the expected costs for all of its financing. This includes payments made on debt obligations, or cost of debt financing, and the required rate of return demanded by ownership, or cost of equity financing. Most publicly listed companies have multiple funding sources, so WACC attempts to balance out the relative costs of different sources to produce a single cost of capital figure.

In theory, WACC represents the expense of raising one additional dollar of money. For example, a WACC of 3.7% means the company must pay its investors an average of $0.037 in return for every $1 in extra funding.

WACC is an important consideration for corporate valuation in loan applications and for operational assessment. Companies look for ways to decrease their WACC through cheaper sources of financing. Issuing bonds may be more attractive than issuing stock, for example, if interest rates are lower than the demanded rate of return on the stock.

Value investors might also be concerned if a company's WACC is higher than its actual return. This is an indication the company is actually losing value, and there are probably more efficient returns available elsewhere in the market.

Taxes can be incorporated into the WACC formula, although approximating the impact of different tax levels can be difficult. One of the chief advantages of debt financing is that interest payments can often be deducted from a company's taxes, while returns for equity investors, dividends or rising stock prices, offer no such benefit.

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