Weighted average cost of capital
The blended return a firm must earn to satisfy everyone who funded it. A single rate, and using it for everything subsidises the risky projects.
Where you will meet it
Weighted average cost of capital appears in 15 learning outcomes on the CFA syllabus. A few of them:
- Contrast what FCFF, FCFE, dividend and residual income models each need as inputs
“The free cash flow to firm model uses cash available to all capital providers at the weighted average cost of capital, giving firm value, from which debt is subtracted to reach equity.”
- Set out what drives a firm's capital structure
“Interest is tax-deductible, so debt carries a tax shield that lowers the weighted average cost of capital — but rising leverage raises the probability and cost of financial distress.”
- Contrast valuing a business by the free cash flow available to equity (FCFE) with valuing it by its free cash flow to the whole firm (FCFF)
“Discounting it at the weighted average cost of capital gives the value of the firm, from which the market value of debt is subtracted to reach equity.”
- Benchmark a company's cost of capital and capital structure against those of its peers
“With weights from market values or a target structure, the weighted average cost of capital is WACC = weight of equity × cost of equity + weight of debt × cost of debt × (1 − t); a debt-to-equity ratio of 0.30 means a debt weight of 0.30 ÷ 1.30, about 23%.”
Learn it properly
Practise it
Practise weighted average cost of capital until it is automatic: questions that explain every wrong option.
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