Weighted Average Cost Of Capital - WACC

What Does Weighted Average Cost Of Capital - WACC Mean?

A calculation of a firm's cost of capital in which each category of capital is proportionately
weighted. All capital sources - common stock, preferred stock, bonds and any other
long-term debt - are included in a WACC calculation. All else help equal, the WACC of a
firm increases as the beta and rate of return on equity increases, as an increase in
WACC notes a decrease in valuation and a higher risk.

The WACC equation is the cost of each capital component multiplied by its proportional
weight and then summing:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Businesses often discount cash flows at WACC to determine the Net Present Value
(NPV) of a project, using the formula:

NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Investopedia explains Weighted Average Cost Of Capital - WACC

Broadly speaking, a company’s assets are financed by either debt or equity. WACC is
the average of the costs of these sources of financing, each of which is weighted by its
respective use in the given situation. By taking a weighted average, we can see how
much interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is
often used internally by company directors to determine the economic feasibility of
expansionary opportunities and mergers. It is the appropriate discount rate to use for
cash flows with risk that is similar to that of the overall firm

Capital Budgeting
What Does Capital Budgeting Mean?
The process in which a business determines whether projects such as building a new
plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective
project's lifetime cash inflows and outflows are assessed in order to determine whether
the returns generated meet a sufficient target benchmark.

Also known as "investment appraisal".

Investopedia explains Capital Budgeting

Ideally, businesses should pursue all projects and opportunities that enhance
shareholder value. However, because the amount of capital available at any given time
for new projects is limited, management needs to use capital budgeting techniques to
determine which projects will yield the most return over an applicable period of time.

Popular methods of capital budgeting include net present value (NPV), internal rate of
return (IRR), discounted cash flow (DCF) and payback period
Capital Rationing
What Does Capital Rationing Mean?
The act of placing restrictions on the amount of new investments or projects undertaken
by a company. This is accomplished by imposing a higher cost of capital for investment
consideration or by setting a ceiling on the specific sections of the budget.

Investopedia explains Capital Rationing

Companies may want to implement capital rationing in situations where past returns of
investment were lower than expected. For example, suppose ABC Corp. has a cost of
capital of 10% but that the company has undertaken too many projects, many of which
are incomplete. This causes the company's actual return on investment to drop well
below the 10% level. As a result, management decides to place a cap on the number of
new projects by raising the cost of capital for these new projects to 15%. Starting fewer
new projects would give the company more time and resources to complete existing
projects.

Return
What Does Return Mean?
The gain or loss of a security in a particular period. The return consists of
the income and the capital gains relative on an investment. It is usually quoted as a
percentage.
Investopedia explains Return
The general rule is that the more risk you take, the greater the potential for higher return
- and loss.

Return is also used as an abbreviation for income tax return, see 1040 Form.

Operating Leverage
What Does Operating Leverage Mean?
A measurement of the degree to which a firm or project incurs a combination
of fixed and variable costs.

1. A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales in a
business increases, each new sale contributes less to fixed costs and more to
profitability.

2. A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.

Investopedia explains Operating Leverage

The higher the degree of operating leverage, the greater the potential danger from
forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be
magnified into large errors in cash flow projections. The opposite is true for businesses
that are less leveraged. A business that sells millions of products a year, with each
contributing slightly to paying for fixed costs, is not as dependent on each individual sale.

For example, convenience stores are significantly less leveraged than high-end car
dealerships
Operating Leverage
What Does Operating Leverage Mean?
A measurement of the degree to which a firm or project incurs a combination
of fixed and variable costs.

1. A business that makes few sales, with each sale providing a very high gross margin,
is said to be highly leveraged. A business that makes many sales, with each sale
contributing a very slight margin, is said to be less leveraged. As the volume of sales in a
business increases, each new sale contributes less to fixed costs and more to
profitability.

2. A business that has a higher proportion of fixed costs and a lower proportion of
variable costs is said to have used more operating leverage. Those businesses with
lower fixed costs and higher variable costs are said to employ less operating leverage.

Investopedia explains Operating Leverage

The higher the degree of operating leverage, the greater the potential danger from
forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be
magnified into large errors in cash flow projections. The opposite is true for businesses
that are less leveraged. A business that sells millions of products a year, with each
contributing slightly to paying for fixed costs, is not as dependent on each individual sale.

For example, convenience stores are significantly less leveraged than high-end car
dealerships