Weighted average cost of capital shows a company how expensive it is to finance new projects or other expenditures by raising money from outside sources. These sources come in two main categories: stocks and bonds. Both of these have different costs to the company, and WACC is a weighted average of the total cost of obtaining funds through debt and equity. A company can lower the WACC by lowering the cost of issuing equity, debt, or both.
Costs of Equity
Investors who buy stocks expect a particular rate of return. Specifically, to buy the stock, they require at least the same return as a risk-free asset, plus a risk premium to compensate them for the additional risk of stocks over bonds. This risk premium consists of the risk premium of the stock market as a whole multiplied by the particular riskiness of the company's stock, which is called the stock's beta. The total formula for the cost of issuing equity is the extra money the company issuing the stock must give to investors -- the risk-free return plus the market risk times the beta.
Cost of Debt
Companies can also sell debt in the form of bonds. Potential bond buyers will expect a return on investment in the form of interest on the debt. The cost of issuing bonds depends on the interest rate the issuer must offer on the bonds to make them attractive to investors. In some countries, including the United States, bond payments are tax-deductible, so the corporate tax rate is also relevant. The full calculation is the yield-to-maturity on the debt times 1 minus the corporate tax rate.
Calculating WACC
Once a company manager has the relative costs of debt and equity, calculating WACC is simple. The manager needs to take the fraction of the company's current capital from stocks and multiply it by the cost of equity. Then the manager should take the fraction of capital from outstanding bonds and multiply that by the cost of debt, and finally the manager needs to add the two figures together. The final result should be a percentage that expresses the cost of raising money from debt and equity.
Lowering WACC
Knowing all the different elements that form the weighted average cost of capital is the first step to taking action to lowering it. With regards to debt, companies can lower their cost of issuing bonds by lowering the interest rate they must offer to investors. They can do this by being more creditworthy: Companies with worse credit ratings must offer higher rates on bonds. The company can also move to a place with a higher tax rate, but this is probably counterproductive. In terms of equity, a company that can offer stocks with low beta is less risky to investors and therefore can offer less of a risk premium. The other elements, the risk-free premium and the general market risk, are outside of the company's control.