Weighted average cost of capital (WACC), in short, is a company’s desired return to satisfy its investors, including common and preferred stockholders, as well as bondholders. By definition, WACC is the weighted average of the mix of debt, preferred stock and common equity. WACC represents a tight correlation between capital structure, risk and return at which a company generates value for its investors. For example, if a company’s rate of return is 15 percent and its WACC is 5 percent, it means that for every invested dollar, the company generates 10 cents of value. But if a company’s rate of return is less than WACC, then the business experiences financial difficulties and it is wise to put your money elsewhere.
Factors That Affect the WACC
The cost of capital is affected by a number of factors. Some are beyond the firm’s control (exogenous), while others are influenced by company’s financing and investment policies (endogenous).
The three most important exogenous factors are level of interest rates, the market risk premium and tax rates. If the interest rates in the economy rise, the cost of debt increases because companies will end up paying bondholders a higher interest rate to obtain debt capital to finance its operating activities. Additionally, higher interest rates increase costs of common and preferred stocks and decrease company competitiveness.
Individual firms have no control over the second factor – market risk premium, which could slightly affect the cost of equity and thus the WACC. The third exogenous factor is the tax rate, which is far beyond the control of a single company. Tax rate is important determinant in the calculation of the cost of debt as used in the WACC. Generally, low capital gains tax rate makes a company’s stock attractive and reduces the cost of equity relative to that of debt. A tax rate decrease will lead to a change in the company’s optimal capital structure toward less debt and more equity.
Along with the exogenous factors, there are a couple of factors a company can use to positively affect its cost of capital: company’s capital structure policy, dividend policy and company’s investment policy. The company’s capital structure is the most important endogenous factor. The right balance between debt and equity should be maintained. Every prospective investor should always keep in mind the following aspects of U.S. Tax Code: corporations can deduct interest expense on debt, but dividend payments are not deductible. Furthermore, the percentage of earnings paid out in dividends can result in a lower stock’s required rate of return and lower WACC, respectively. In case a firm’s payout ratio (dividends/ earnings) is relatively high, the company must issue new shares of stock to fund its capital budget and will incur flotation cost associated with issuing new shares. The whole process will negatively affect company’s cost of capital.
All investors expect rewarding returns for entrusting their money, and WACC is one metric that could help them to make their investment decisions. For additional information on picking solid investments, check out this report on Understanding the Stock Market and How to Buy Stocks.