Calculating the WACC

A firm's weighted average cost of capital (WACC) is a difficult concept to understand. It may be helpful to think of a company's WACC in relation to the weighted average return on your own investment portfolio.  You may own $10,000 in a money market fund that has an expected yearly return of 6%. You also may own $10,000 of a preferred stock with an expected return of 8%. And you also may own $80,000 market value of a common stock with an expected return of 10%.  The expected weighted average return of your $100,000 (in total) investment portfolio equals:

Exp. Port. = ($10,000 x .06) + ($10,000 x .08) + ($80,000 x .10) =   $9,400 = 9.4%
Return                                               ($100,000)                                        $100,000

A company's WACC is very similar to your investment portfolio's weighted average return as described above. It's simply the weighted average expected cost for the company's various types of obligations—debt, preferred stock, and common stock—that are issued by the corporation to finance its operations and investments.

The company's WACC is a very important number, both to the stock market for stock valuation purposes and to the company's management for capital budgeting purposes. In an analysis of a potential investment by the company, investment projects that have an expected return that is greater than the company's WACC will generate additional free cash flow and will create positive net present value for stock owners. These corporate investments should result in an increase in stock prices.  These projects are good things! Investments that earn less than the firm's WACC will result in a decrease in stockholder value and should be avoided by the company.