Weighted average cost of capital and cost of capital are both concepts of finance that represent the cost of money invested in a firm either as a form of debt or equity or both. Cost of equity refers to the cost of selling shares to shareholders to obtain equity capital and cost of debt refers to the cost or the interest that must be paid to lenders for borrowing money. These two terms cost of capital and WACC are easily confused as they are quite similar to each other in concept. The following article will explain each providing formulas on how they are calculated.
What is Cost of Capital?
Cost of capital is the total cost in obtaining debt or equity capital. In order for an investment to be worthwhile, the rate of return on the investment must be higher than the cost of capital. Taking an example, the risk levels of two investments, Investment A and Investment B, are the same. For investment A, the cost of capital is 7%, and the rate of return is 10%. This provides an excess return of 3%, which is why investment A should go through. Investment B, on the other hand, has cost of capital of 8% and rate of return of 6%. Here, there is no return for the cost incurred and investment B should not be taken into consideration.
However, assuming that the treasury bills have the lowest level of risk, and have a return of 5%, this may be more attractive than both options since risk levels are very low, and return on 5% is guaranteed since the T bills are government issued.
What is WACC?
WACC is a bit more complex than the cost of capital. WACC is calculated by giving weights to the company’s debt and capital in proportion to the amount in which each is held. WACC is usually calculated for various decision making purposes and allows the business to determine their levels of debt in comparison to levels of capital.
The formula for calculation is; WACC = (E / V) x Re + (D / V) x Rd x (1 – Tc). Here, E is the market value of equity and D is the market value of debt and V is the total of E and D. Re is the total cost of equity and Rd is the cost of debt. Tc is the tax rate applied to the company.
What is the difference between Cost of Capital and WACC?
Cost of capital is the total of cost of debt and cost of equity, whereas WACC is the weighted average of these costs derived as a proportion of debt and equity held in the firm.
Both, Cost of capital and WACC, are made use in important financial decisions, which include merger and acquisition decisions, investment decisions, capital budgeting, and for evaluating a company’s financial performance and stability.
Summary:
Cost of Capital vs WACC
• Weighted average cost of capital and cost of capital are both concepts of finance that represent the cost of money invested in a firm either as a form of debt or equity or both.
• In order for an investment to be worthwhile, the rate of return on the investment must be higher than the cost of capital.
• WACC is calculated by giving weights to the company’s debt and capital in proportion to the amount in which each is held.