Chapter 25

Weighted average cost of capital

A firm’s ‘weighted average cost of capital’ (or WACC) is a financial metric used to measure the cost of capital to a firm. It is a weighted average of the firm’s cost of debt and its cost of equity.

When to use it

  • To decide what discount rate to use in capital budgeting decisions.
  • To evaluate potential investments.

Origins

The term ‘cost of capital’ was first used in an academic study by Ferry Allen in 1954: he discussed how different proportions of equity and debt would result in higher or lower costs of capital, so it was important for managers to find the right balance.

However, this informal analysis was eclipsed by Modigliani and Miller’s seminal paper, ‘The cost of capital, corporation ...

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