Definition:

Weighted Average Cost of Capital (WACC) is a financial metric that calculates a firm's cost of capital, where each category of capital is proportionately weighted. It represents the average rate that a company is expected to pay to finance its assets, giving investors an idea of the minimum return required to justify an investment.

Formula:

WACC = (E/V) * Re + (D/V) * Rd * (1-Tc)

where:

E = Market value of equity

V = Total market value of equity and debt (E + D)

Re = Cost of equity

D = Market value of debt

Rd = Cost of debt

Tc = Corporate tax rate

How to use the metric:

WACC is used by companies to evaluate investment opportunities. It serves as a hurdle rate for capital projects, meaning that any project with a return greater than the WACC is considered value-adding. It is also used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.

Limitations:

WACC assumes that the capital structure of a company remains constant over time, which may not be realistic. It also relies on market values, which can be volatile and may not accurately reflect the true cost of capital. Additionally, estimating the cost of equity can be challenging and subjective.

Applies to:

WACC is applicable across various industries, particularly those with significant capital investments, such as manufacturing, utilities, and telecommunications, where understanding the cost of financing is crucial for investment decisions.

Doesn't apply to:

WACC may not be as relevant for industries with minimal capital requirements, such as certain service-based sectors, where the cost of capital is less of a concern. Additionally, startups or companies with unstable capital structures may find WACC less applicable due to the difficulty in accurately estimating the components.

Summary:

WACC is a vital financial metric used to assess the cost of capital for a company, helping in investment decision-making and valuation. While it provides valuable insights, its accuracy depends on stable capital structures and reliable market data, making it less applicable in certain contexts.