Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is a weighted average of the after-tax required rates of return on a company’s common stock, preferred stock, and long-term debt, where the weights are the fraction of each source of financing in the company’s target capital structure.

Formula

r_{WACC} = \displaystyle\frac{D}{D+E} \times r_D \times (1-t) + \displaystyle\frac{E}{D+E} \times r_E

where

  • r_{WACC} is the WACC
  • r_D is the before-tax marginal cost of debt
  • r_E is the cost of equity
  • D denotes the market value of the shareholders’ outstanding debt
  • E denotes the market value of the shareholders’ outstanding equity
  • t is the marginal tax rate

Capital Structure

A company’s capital structure is the mix of debt and equity the company uses to finance its business. The goal of a company’s capital structure decision—the choice between how much debt and how much equity a company uses in financing its investments—is to determine the financial leverage or capital structure that maximizes the value of the company by minimizing the weighted average cost of capital. The weighted average cost of capital (WACC) is given by the weighted average of the marginal costs of financing for each type of financing used.