Weighted average cost of capital
The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.
Corporations raise money from two main sources; equity and debt. Thus the capital structure of a firm is comprised of three main components (preferred equity, common equity and debt (typically bonds and notes). The WACC takes into account the relative weights of each component of the capital structure and presents the expected cost of new capital for a firm.
The formula
WACC = Weight of Preferred Equity * Cost of Preferred Equity
+ Weight of Common Equity * Cost of Common Equity
+ Weight of Debt * Cost of Debt
Effect on valuation
The economists Merton Miller and Franco Modigliani showed that in a perfect economy without taxes, a firm's cost of capital (and thus the valuation) does not depend on the debt-equity ratio. However, many governments allow a tax deduction on interest and thus in such an environment, there is a bias towards debt financing.
See also
