Weighted Average Cost of Capital

I will cover all financial KPI – FCF, ROIC, economic profit, etc. in detail in Part III, devoted to financial analysis. In this section, I will cover only WACC – your Weighted Average Cost of Capital.

WACC is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Therefore, your company ROIC must exceed your WACC, or your business (or project) makes no economic sense – these funds must be invested elsewhere, where they will generate acceptable return.

Companies raise money from a number of sources: common stock, preferred stock, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on.

Different securities, which represent different sources of finance, are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate WACC and the more complex is the formula for WACC calculation.

The general formula is, indeed, quite frightening. Fortunately, most companies are financed with just debt and equity, so the formula for WACC becomes much more manageable (and less frightening).

Cost of debt is your effective (i.e. real rather than declared in your loan contracts) interest rate that you actually pay on your debt. It is itself a weighted average of your interest rates paid on different loans (weighted by loan amounts, of course). Including tax adjustments as your interest payments are tax-deductible. So it is an after-tax cost of debt.