Your company's weighted average cost of capital, or WACC, tells you how much it costs the firm to use money for projects intended to generate growth. Whether you use the owners' money or borrowed money for capital investment, that money comes at a cost. Looking at how WACC gets calculated reveals how management can influence the cost of capital.


The simplest formula for WACC includes four elements. The first is the percentage of financing that comes from equity, or the owners' money. This could be money out of the owners' pockets, cash from investors, or money generated by the operations of the business itself. The second is the percentage of financing that comes from debt -- borrowed money. These percentages are called weights, and the formula denotes them as "wE" and "wD," respectively. The third element is the required rate of return on equity capital, or "rE." This is the return that the owners' money has to generate for the project to be worthwhile -- essentially, it is what the owners could get if they invested the money somewhere else at the same level of risk. The last element is the interest rate on borrowed money, or "rD." The simplified formula is as follows: WACC = (wE x rE) + (wD x rD). For now, the formula leaves out tax considerations.


Management can affect WACC through its decisions on how to "weight" the financing for projects. Say the company can borrow money at 5 percent interest, and the owners could get an 8 percent return on their money if they invested it elsewhere. If the company finances projects with an equal mix of debt and equity, then its WACC would be: (0.5 x 0.08) + (0.5 x 0.05) = 0.065, or 6.5 percent. If the owners decided to borrow 90 percent of the money, WACC would then be: (0.1 x 0.08) + (0.9 x 0.05) = 0.053, or 5.3 percent.

Debt Management

If a company could borrow at 5 percent and had a required return on equity of 8 percent, then it would appear to be cheaper to borrow every cent the company needed. But as a company's debt increases, so does the risk associated with lending it more money, because it raises the possibility that the company won't be able to repay if it runs into trouble. When a borrower is a higher credit risk, lenders charge a higher interest rate, which in turn increases the WACC. So management can also influence WACC through how it manages debt -- making sure the company "lives within its means" and doesn't take on more than it can handle.

Tax Strategies

For simplicity, the WACC formula provided earlier -- (wE x rE) + (wD x rD) -- left out one key consideration: taxes. Interest paid on borrowed money is a deductible business expense. If you pay, say, $1,000 in interest, then you reduce your taxable profit by $1,000. If your tax rate were 28 percent, that would save you $280 on taxes, so the net cost of the interest would actually be only $720. The higher the company's tax rate, the cheaper it actually becomes to use borrowed money, because the deducted interest produces a larger tax savings. Decisions made by owners or managers can protect income from tax or expose it to tax, affecting the tax rate applied to company profits, which in turn affects the WACC. The full WACC formula incorporates these tax effects: WACC = (wE x rE) + (wD x rD)(1 - t), where "t" is the effective tax rate on company profits.