What is WACC?

If you're investing in companies like Reliance, Infosys, or Zomato, you might’ve heard the term WACC. But what exactly is it? Let's assume you're stuck in this situation where you're at a chai tapri with your friends. One of them says, “Bro, Reliance ka stock lena chahiye ya nahi?” And someone replies, “Depends on the company’s WACC, bro.” Now you’re just sitting there thinking, “What is WACC?” So here we will discuss WACC.

About WACC

WACC stands for Weighted Average Cost of Capital. In simple terms, it refers to the cost a company incurs to raise money from investors (through shares) and banks (via loans). A company needs money to run and grow. That money comes from:

• Shareholders (they expect returns)
• Banks or lenders (they charge interest)

Weighted Average Cost of Capital is the average of both these costs. It informs the company about the cost of raising money. For example, let's imagine a cup with  50% chai, which is cheap, and 50% which is expensive, so the final cost is an average of both. That's how the Weighted Average Cost of Capital works. So if a company uses both debt, which is like a loan, and equity, which is like a share, WACC is the average cost of both.

Why WACC Matters for a Business?

Weighted Average Cost of Capital indicates whether a company's spending is worthwhile. It helps answer questions like:

• Should we launch a new product or project?
• Will this expansion bring enough profit?
• Are we using our funds wisely?

If the company earns more than its WACC, it’s adding value and making smart moves.  If it earns less than WACC, it’s actually losing money, even if it’s making profits on paper.

Imagine WACC as the minimum target every rupee invested must beat. If returns don’t clear that bar, the business is on the wrong track.

WACC Calculation

Before calculating WACC, you need to understand a few basic terms. These are the ingredients that go into the WACC formula.

1. Market Value of Equity (MVE):

This is the total value of the company’s shares in the market. Formula: MVE = Share Price × Total Outstanding Shares

For example, if a company’s share price is ₹500 and it has 10 crore shares: MVE = ₹500 × 10 crore = ₹5,000 crore

2. Total Market Value (V): 

This is the combined value of both equity and debt. Think of it as the total capital a company is working with. Formula: V = Market Value of Equity + Market Value of Debt

3. Market Value of Debt:

This is the value of all the loans or borrowings the company has. If investors have bought the company’s bonds or other debt instruments, this is counted here. It shows how much loan money the company is using to run the business.

4. Required Rate for Equity:

This is what shareholders expect to earn after investing in the company. It’s like their minimum profit expectation. If this return isn’t met, investors may lose confidence in the company

5. Tax rate on the corporation:  

This is the income tax rate a company pays to the government. In India, it’s usually around 25-30% depending on the company’s size and income bracket.

6. Cost of Debt: 

This is the interest a company pays on the loans or borrowings it has taken. Lower cost of debt = cheaper borrowing

WACC Formula 

The weighted average cost of capital is easy to calculate. Its calculation is done by using the given formula :

WACC = (E/V * Re) + (D/V * Rd * (1 - Tc)) )

E: E means “market value of Equity”
V:  V is “Total Market Value”
Re: Re means “Required Rate of return for Equity”
D: D is “market value of Debt”
Rd: Rd stands for “Cost of Debt”
Tc: Tc means “Tax rate on a corporation”

WACC Example: ABC Company

Let’s take an example to see WACC in action. Let's take “ABC” as the company. So ABC makes water bottles to sell. ABC’s market value of debt is Rs. 40 crore, and the market value of equity is Rs. 80 crore. Also, the corporate tax is 0.5%, the cost of equity is 10% and the cost of debt is 4%.

Therefore,

Total Capital Value  = Market Value of Debt + Market Value of Equity

=  Rs 40 crore  +  Rs 80 crore
Total capital value =  Rs 120 crore.

Now calculating WACC

The value of E = Rs 40 crore , V =  Rs 120 crore , D = Rs. 80 crore 

Re = 10% , Rd = 4% , Tc =  0.5%
E/V = Rs 40 crore / Rs 120 crore = 0.33
D/V = Rs 80 crore / Rs 120 crore = 0.66

WACC = (0.33 * 10%) + ((0.66 * 4%) (1 - 0.5%))
= 3.3%  + 2.64%* 0.5%
= 4.62%

Importance of WACC

WACC is more than just a financial formula. It’s one of the most important tools companies and investors use to make smart decisions. Here’s why WACC matters:

1. Measures Company Performance

WACC shows whether the company is generating enough returns to cover the cost of its capital. If profits are higher than WACC, the business is doing well. If profits are lower, it means losing value.

2. Used in Business Valuation

Analysts use WACC when calculating how much a company is really worth using methods like Discounted Cash Flow (DCF).

• Lower WACC = Higher valuation.
• Higher WACC = Lower valuation.

3. Helps in Budget Planning

Before starting any new project, companies use WACC to check if the expected profit is more than the cost of capital.
If not, the project may not be worth it.

Understanding Cost of Capital

Cost of capital is the minimum return a company needs to generate to stay profitable. It tells investors: "If you give us your money, here’s the return you can expect." If the return is lower than the cost of capital, investors lose trust and the company looks risky. Why it matters:

• Helps companies judge investment risk.
• Shows whether projects will earn more than they cost.
• Tells investors what minimum return to expect.

In short, WACC and cost of capital are crucial for evaluating the health, value, and future of a company.

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WACC Benefits

WACC isn’t just a formula; it’s a powerful tool that helps both companies and investors make smart financial decisions. Here’s how WACC is useful:

1. Compares the Cost of Equity and Debt

WACC shows the combined cost of raising money through shares (equity) and loans (debt). It gives a clear picture of how expensive it is for the company to raise capital.

2. Acts as a Risk Indicator

• High WACC = Riskier business (cost of capital is high)
• Low WACC = Safer business (raising money is cheaper)

Investors use this to judge how stable or risky a company is.

3. Helps Investors Make Better Decisions

Investors check WACC to see if a company is worth investing in. If a company earns more than its WACC, it’s a sign of good returns.

4. Useful for Internal Business Planning

Companies use WACC as a hurdle rate, a minimum return required on any project or investment. If the return is less than WACC, the project is usually rejected.

Where is WACC Used?

WACC isn’t just for finance geeks; it’s used in real business decisions every day. Here’s how companies and investors use it:

1. Investment Decisions

Before starting a new project or launching a product, companies ask: “Will this project earn more than our WACC?”
If yes, go ahead. If no, skip it.

2. Company Valuation

WACC is used in methods like Discounted Cash Flow (DCF) to figure out a company’s true worth.

• Lower WACC = Higher valuation
• Higher WACC = Lower valuation

3. Risk Analysis

• High WACC means the company is risky, and it costs more to raise money.
• Low WACC means the company is stable and borrowing is cheaper.

4. Budget Planning

WACC helps companies decide how much to invest in:

• Marketing campaigns
• R&D (research and development)
• Business expansion

If the expected return on any spending is less than the WACC, it’s usually not worth the money.

Conclusion

In Conclusion, WACC tells a company if it's earning enough profit to cover its cost of money. It’s the minimum return they must achieve to grow. Before investing in any Indian company, ask: "Is it beating its WACC?" If yes, the company is healthy. If not, it’s burning money. So next time you're on Zerodha or Groww, remember: “ to watch the WACC first, before investing on it!”