The blended cost of debt and equity used to finance a business.
Weighted Average Cost of Capital (WACC) calculates a company's overall cost of capital, weighting each category of financing (common equity, preferred stock, debt) proportionally by its market value.
The average interest and return rate a company pays for all the money funding its operations, taking into account both bank loans and shareholder investments.
A cocktail where 60% is equity costing 15% and 40% is bank debt costing 8% after taxes. The blended flavour (cost) of the drink is 12.2%.
Total Enterprise Value: ₹100 crore. Equity: ₹60 crore (60% weight, 16% cost). Debt: ₹40 crore (40% weight, 9% cost with 25% tax shield = 6.75%). WACC = (0.60 × 16%) + (0.40 × 6.75%) = 9.6% + 2.7% = 12.3%.
Using book values instead of market values when computing weights can distort WACC significantly, leading management to misprice acquisitions or understate project hurdle rates.
WACC is the essential discount rate in Discounted Cash Flow (DCF) valuation models. Minimizing WACC through optimal capital structure maximizes enterprise value.