Finance Definitions: Weighted Average Cost of Capital

When we looked at return on invested capital a few weeks ago, we briefly touched on the weighted average cost of capital. While the brief definition helped us to define ROIC, it wasn't nearly as in-depth of a definition as this term deserves. So let's take a ride through the ins and outs of weighted average cost of capital (WACC).

WACC: The Basics

First, before we go too far, let's quickly redefine capital: capital is anything of cash value that the company owns, including cash and goods that can be sold for cash. Okay, now that that is out of the way, let's look at WACC.

Generally speaking, the weighted average cost of capital (also known as the shorter versions of "cost of capital" and "WACC"), is the total amount of money that it would take to fund new projects. Since businesses use both borrowed money and cash on hand to finance new capital projects, there is a cost associated with every new project, building, piece of equipment, etc. that the company wishes to tackle or purchase.

More on WACC

Now on to the nitty-gritty: the "weighted" part of WACC is where some fancy math comes in. Since I'm not a mathematician and the average investor will not be using complex algebra to actually determine WACC, let's just look at the generalities behind the principles.

When business and stock market analysts determine the WACC, they weigh the assets comparable to their use within projects and within the company. All of these assets are then weighed to determine the average interest that the company pays on its debts, all in terms of pennies on the dollar.

What This Means for You

Most often, the WACC is used internally, or within the business itself, to determine if purchases, expansions or mergers are in the best interest of the company. However, the WACC is also listed on the stock balance sheet for investors to use in their own assessment before purchasing stock in the company. In that case, you as the potential investor should know that an increase in weighted average cost of capital means that the company has decreased in value and is now a higher risk stock can help you make your stock purchasing decision.

Overall, when used in conjunction with other figures on the stock balance sheet, the WACC can help you, as a potential investor, determine whether investing in the company is a good move or a poor investment.

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