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cost of capital (WACC)

Also called: WACC, weighted average cost of capital, cost of capital

The return lenders and owners expect for financing the company, blended by their shares (weighted average cost of capital).

The cost of capital is what the company's money costs: the return its lenders and owners expect for financing it. Since most companies use both, it is usually computed as the weighted average cost of capital (WACC): each source's expected return weighted by its share of the financing. WACC = D share × cost of debt + E share × cost of equity.

Debt is cheaper because lenders are paid first, on a schedule, whatever happens. Owners are paid last and only when there is profit, so they expect more. In practice the cost of debt is taken after tax, because interest lowers taxable profit; simple examples often leave taxes out.

The cost of capital is the floor for an average-risk bet: a project that earns less doesn't pay the people whose money it uses. It is also the starting point for hurdle rates, which add a premium for riskier bets. Adding cheap debt lowers the formula's result on paper, but more debt makes the owners' share riskier, so the return they expect rises and much of the apparent saving disappears.

Example

A quarter of Klasna's financing is a bank loan at 16% a year; three quarters is the founders' and investors' money, who expect about 28%. Taxes left out:

WACC = 25% × 16% + 75% × 28% = 4% + 21% = 25%.

That is why Klasna discounts average-risk bets at 25%. With 40% debt at the same rates the formula gives 40% × 16% + 60% × 28% = 6.4% + 16.8% = 23.2%, but only if the owners don't ask for more than 28% for their now riskier share. And the bank wants its interest in August too, when Klasna's cash is lowest.

Common mistakes

  • Taking the cheapest source as the cost. The loan rate is one piece; the cost of capital is what all of the money costs.
  • Assuming more debt makes money cheaper. The owners' expected return rises with the risk debt adds.
  • Using it for every bet. It fits average risk; riskier bets need a higher hurdle.
  • Weighting by the wrong shares. Use the mix the company actually finances itself with, not the mix it wishes it had.
  • Treating the result as precise. The owners' expected return is an estimate; round the rate and test the answer at nearby values.

Learn it in the course