A high weighted average cost of capital, or WACC, is typically a signal of the higher risk associated with a firm's operations. Investors tend to require an additional return to neutralize the additional risk.
A company's WACC can be used to estimate the expected costs for all of its financing. This includes payments made on debt obligations (cost of debt financing), and the required rate of return demanded by ownership (or cost of equity financing).
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.
Here is a more thorough example of a company that needs money for growth: Imagine a newly-formed widget company called XYZ Industries that must raise $10 million in capital so it can open a new factory. So the company issues and sells 60,000 shares of stock at $100 each to raise the first $6,000,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%. XYZ then sells 4,000 bonds for $1,000 each to raise the other $4,000,000 in capital. The people who bought those bonds expect a 5% return, so XYZ's cost of debt is 5%.
The more complex a company's capital structure, the more complex and onerous the WACC calculation will be. But it’s a process well worth undertaking because it can pave the pay for successful and profitable operations.
WACC is an important consideration for corporate valuation in loan applications and operational assessment. Companies seek ways to decrease their WACC through cheaper sources of financing. For example, issuing bonds may be more attractive than issuing stock 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 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 challenging. 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.
The Bottom Line
Weighted average cost of capital is an integral part of a discounted cash flow valuation and is, therefore, a critically important metric to master for finance professionals, especially those who occupy corporate finance and investment banking roles.