What is WACC and capital budgeting?


Quick Answer

The weighted average cost of capital, or WACC, refers to the calculation of the average after-tax cost of a company's different capital sources, while capital budgeting is the process used by companies to evaluate potential investments or expenditures, according to Investopedia. Both concepts are used during financial planning.

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Full Answer

According to a Forbes report, most companies have two primary sources of financing: equity and debt. WACC is the average cost of raising these monies. Investopedia provides the formula for calculating WACC as E/V*Re + D/V*Rd*(1-Tc)where:

  1. E/V = Financing percentage
  2. E = Market value of equity
  3. D = Market value of company's debt
  4. Re = Cost of equity
  5. Rd = Cost of debt
  6. V = Company's total market value
  7. Tc = Tax rate

WACC plays a major element in capital budgeting. Financial planners use it in gauging a company's fiscal readiness in investing in new projects. Companies with lower WACC figures will find it easier to afford new investments compared to others with high WACC values. Other key elements involved during capital budgeting include the time value of money and the internal rate of return. The time value of money takes into consideration the potential earning capacity of money, while the internal rate of return considers the expected gains of the proposed investment weighed against the required capital.

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