Composite Cost of Capital
Composite cost of capital is a company’s cost to finance its business, determined by, and also referred to as “weighted average cost of capital” or WACC. The calculation involves multiplying the cost of each capital component by its proportional weight and taking the sum of the results. A company’s debt and equity, or its capital structure, typically includes common stock, preferred stock, bonds and any other long-term debt. A high composite cost of capital, indicates that a company has high borrowing costs; a low composite cost of capital implies lower borrowing costs.
To help understand composite cost of capital, think of a company as a pool of money from two separate sources: debt and equity. Proceeds earned through business operations are not considered a third source because, after a company pays off debt, the company retains any leftover money that is not returned to shareholders (in the form of dividends) on behalf of those shareholders.
A company’s management uses the company’s composite cost of capital in internal decision making. For example, it might use it to help decide whether the company could profitably finance a new project. Investors may use a company’s composite cost of capital as one of several factors in deciding whether to buy the company’s stock. While the cost of issuing debt is fairly straightforward, the cost of issuing stock has more variables. A company with a relatively low WACC may be better positioned to grow and expand, potentially rewarding shareholders.
How Investors Use Composite Cost of Capital?
Securities analysts frequently use WACC when assessing the value of investments. For example, in discounted cash flow analysis, the WACC can be applied as the discount rate for future cash flows in order to derive a business’s net present value. WACC may also be used as a hurdle rate against which to gauge ROIC performance. WACC is also essential in order to perform economic value added (EVA) calculations.
While composite cost of capital is important, the average investor would find that calculating WACC is a complicated process requiring detailed company information. Nonetheless, understanding WACC can help investors understand its significance when they see it in brokerage analysts’ reports.
Because certain elements of the WACC formula, like cost of equity, are not consistent values, various parties may report them differently for different reasons. As such, while WACC can often help lend valuable insight into a company, one should always use it along with other metrics when determining whether or not to invest in a company.