Weighted Average Cost of Capital

The weighted average cost of capital (WACC) reflects the combined cost of debt and equity with the weights of these capital sources based on their market value rather than book value. Once the WACC applicable to the approximate optimum capital structure is achieved, additional debt causes the WACC to rise, reflecting the added risk higher financial leverage creates. This chapter shows some common errors in computing cost of capital. There is a substantial body of financial theory available to quantify the costs of debt and equity capital sources and to deal with them on a combined basis through a WACC. When these procedures are applied properly, risk can be measured accurately and, in the process, managed to maximize returns.