weighted average cost of capital
Weighted Average Cost of Capital is the blended cost a company pays for all the money it uses, mixing what it owes lenders and what it owes shareholders.
In plain English
Borrowing ₦2,000,000 from your uncle feels different from asking your business partner to put in ₦2,000,000. Your uncle wants his money back with a bit of interest, calmly, no drama. Your partner wants a share of the profits forever, and if the business does brilliantly, she expects to eat well too.
A company faces this same mix every day, except at a much bigger scale. It gets money from lenders who charge interest, and it gets money from shareholders who expect returns through dividends or a rising share price. Each source has its own cost, and neither is free, even when it feels like it.
Weighted Average Cost of Capital, often shortened to WACC, is the single number that blends these two costs together, in proportion to how much of each the company actually uses. If a company is funded 60 percent by debt and 40 percent by equity, WACC takes the cost of that debt and the cost of that equity and mixes them in exactly that ratio.
This number matters because it becomes the obstacle rate for new projects. A company in Lagos considering a new factory will compare the expected return on that factory against its WACC. If the factory returns less than the WACC, it is calmly destroying value, even if it looks profitable on paper.
In the United Kingdom, a listed company considering a takeover uses WACC to work out whether the deal actually creates value or just makes the balance sheet bigger. A Nigerian in London sending money home to fund a family business might not calculate WACC formally, but the business itself, once it grows and takes on a bank loan alongside family equity, will need to know its number to price new decisions properly.
A company has ₦70,000,000 in debt costing 12 percent after tax, and ₦30,000,000 in equity costing 18 percent. WACC equals (0.7 x 12%) plus (0.3 x 18%), which comes to 8.4% plus 5.4%, giving a WACC of 13.8%.
Questions people ask
Why does WACC use after tax cost of debt?
Interest payments reduce a company's tax bill, so the real cost of borrowing is lower than the stated interest rate. WACC reflects this by using the after tax figure, giving a more honest consider of what debt truly costs the business.
Why is equity usually more expensive than debt?
Shareholders take on more risk than lenders because they get paid last if things go wrong, and they have no fixed repayment date. To accept that risk, they demand a higher return, which makes equity the pricier source of funding.
Can WACC change over time?
Yes, it moves whenever the mix of debt and equity changes, or when interest rates and investor expectations shift. A company that takes on more debt, or one operating in a riskier economy, will usually see its WACC rise.
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