It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
Given a number of competing investment opportunities, investors are expected to put their capital to work in order to maximize the return.
Importantly, both cost of debt and equity must be forward looking, and reflect the expectations of risk and return in the future.
Suppose a company considers taking on a project or investment of some kind, for example installing a new piece of machinery in one of their factories.
The new debt-holders and shareholders who have decided to invest in the company to fund this new machinery will expect a return on their investment: debt-holders require interest payments and shareholders require dividends (or capital gain from selling the shares after their value increases).
Suppose that one of the sources of finance for this new project was a bond (issued at par value) of $200,000 with an interest rate of 5%.
It is commonly computed using the capital asset pricing model formula: where Beta = sensitivity to movements in the relevant market.
The risk premium varies over time and place, but in some developed countries during the twentieth century it has averaged around 5% whereas in the emerging markets, it can be as high as 7%.
The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and capital structure.
Rather, it represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.
Calculation of WACC is an iterative procedure which requires estimation of the fair market value of equity capital[citation needed] if the company is not listed.
The Adjusted Present Value method (APV) is much easier to use in this case as it separates the value of the project from the value of its financing program.
This is because adding debt increases the default risk – and thus the interest rate that the company must pay in order to borrow money.
By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well.
Lambert, Leuz and Verrecchia (2007) have found that the quality of accounting information can affect a firm's cost of capital, both directly and indirectly.