Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is a measure of the cost of capital for a company. It is calculated by taking the weighted average of the cost of each type of capital that the company uses.

Formula:

WACC = (E/V)rE + (D/V)rD

where:

• WACC is the weighted average cost of capital
• E is the market value of the company’s equity
• V is the total value of the company’s assets
• rE is the cost of equity
• rD is the cost of debt

Steps:

1. Calculate the weighted average cost of equity (WACC) using the formula above.
2. Use the weighted average cost of equity to calculate the discount rate for future cash flows.

Assumptions:

• The company is in equilibrium and is not growing or shrinking.
• The company is not using any debt.
• The company has a constant cost of capital.
• The company will not pay any dividends.

Advantages:

• WACC provides a single measure of the cost of capital for a company.
• WACC is used to calculate the present value of future cash flows.
• WACC is a flexible measure of cost of capital that can be adjusted for different assumptions.

Disadvantages:

• WACC does not reflect the riskiness of a company’s investments.
• WACC does not reflect the company’s tax rate.
• WACC does not reflect the company’s operating leverage.