Financial Glossary
Weighted Average Cost of Capital (WACC)
WACC is the blended, after-tax rate of return a company must earn on its total asset base to satisfy all of its capital providers -- debt holders and equity holders -- proportionally to their contribution to the total capital stack. It is calculated as: (weight of equity multiplied by cost of equity) plus (weight of debt multiplied by cost of debt multiplied by (1 minus tax rate)). The debt component is tax-adjusted because interest expense is deductible, reducing its effective cost. WACC functions as the hurdle rate for capital budgeting: an investment that earns a return above WACC creates value; one that earns below destroys it.
Problem & Application
A real estate operating company is funded with 60% equity (required return 12%) and 40% debt at a 7% interest rate, with a 25% effective tax rate. WACC is (0.60 multiplied by 12%) plus (0.40 multiplied by 7% multiplied by (1 minus 0.25)), equaling 7.2% plus 2.1%, or 9.3%. Any project the company evaluates -- adding rental cabins, upgrading amenities, acquiring an adjacent parcel -- must project an unlevered return above 9.3% to be value-accretive. If interest rates rise and the cost of new debt increases to 9%, WACC climbs to approximately 9.9%, making several marginal projects no longer worth pursuing. This is one mechanism by which rising rates slow capital investment: they do not just raise borrowing costs, they raise the minimum acceptable return on all investments, shrinking the universe of viable projects.
In Short
WACC is a critical metric in evaluating investment decisions and capital costs. Maintaining an optimal WACC helps companies make financially sound decisions while managing risk.