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Why is the Weighted Average Cost of Capital so important?

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  • Serge answered 8 years ago
Because it tells you how much return you need to produce to satisfy the different fund providers of your company, like banks, long-term receivables from other financial (or other) sources as well as giving back dividends to shareholders. All these stakeholders have different expectations on return.

To simplify to the extreme, banks generally have a fixed rate, lower than shareholder return expectations because the latter bear also higher risk. An average of all these return expectations weighted by the amount of capital each provided/contributed, gives you your WACC.

Assuming you have 50% of your capital provided by a long-term loan from a bank at 5% and the rest is shareholding capital in an industry that for similar risk returns about 7% (so will therefore your shareholders expect 7%), your WACC is 6%. Any investment the company makes needs at least to return 6% so that it can pay the interest on the loan from the bank and return 7% to its shareholder. It is what we call a hurdle rate: below no-go, above go-ahead.
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why is the Weighted Average Cost of Capital so important?
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