Weighted Average Cost of Capital (WACC) is defined as the minimum return that a company must generate to satisfy its owners, creditors, and other providers of capital or else it would make more sense for them to invest elsewhere. Since there are different components that make up a company’s overall capital, each possibly with a different cost associated with them, this method blends them into an overall cost, proportionally weighting each component based on its size.
Let’s look at a simple analogy first. Suppose we are interested in determining how much a bag of mixed nuts cost. Peanuts make up 60% of the bag and cost $1.99 / lb. Almonds are just 20% of the mix but cost $3.99 / lb. The final 20% of the bag is Macadamia nuts at a cost of $5.99 / lb. How much does 1 pound of mixed nuts cost? We have all the information we need to answer this question. We know the relative percent, or weight, carried by each component and we also have a cost for that component. Continue reading