What does the Weighted Average Cost of Capital (WACC) represent?

The Weighted Average Cost of Capital (WACC) represents the overall cost of capital for a firm, reflecting the cost of financing from both equity and debt sources. It is calculated by taking a weighted average of the cost of equity and the after-tax cost of debt, where the weights are determined by the proportion of each component in the company’s capital structure.

This measure is crucial because it provides insight into how much a company must earn on its investments to satisfy its investors or creditors. The WACC thus serves as a critical threshold; if a company's return on invested capital exceeds its WACC, it is creating value for shareholders.

The cost of equity represents the return that investors expect for holding a company's equity, while the after-tax cost of debt reflects the effective rate that the company pays on its borrowed funds, adjusted for the tax shield that debt provides. By including both elements, the WACC gives a comprehensive view of the total cost of financing for a company, making it a vital concept in corporate finance for assessing investment projects and capital budgeting decisions.