A firm’s Weighted Average Cost of Capital (WACC) represents a firm’s average after-tax cost of capital from all sources, including common shares, preferred shares, bonds, and other forms of debt where each source comes with a specific weight in the total.
In other words, the cost of each type of capital is weighted by its percentage of total capital and they are added together to become WACC. WACC is also used as the discount rate for future cash flows in discounted cash flow analysis.
In essence, this is the opportunity cost of capital for investors, calculated on the amount of capital they invest in the business.
How to calculate WACC
WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)
Where,
- E: equity market value
- D: debt market value
- V: the sum of the equity and debt market values (E+D)
- Re: equity cost
- Rd: debt cost
- Tc: the current tax rate for the firm