What Is WACC and Why Is It Important?

Within the world of leasing the acronym WACC comes up a lot but is rarely understood by anyone outside of the finance department or the C-suite. However, it’s a vitally important financial concept for reviewing the financing of assets. The most recent Google snippet (clearly the most popular…) defines it as:

"The weighted average cost of capital (WACC) is the average rate that a business pays to finance its assets. It is calculated by averaging the rate of all of the company's sources of capital (both debt and equity), weighted by the proportion of each component."

The WACC is commonly used in financial decision-making and must be applied to all potential investments in order to accurately calculate the overall cost of each project or investment.

Here's a step-by-step breakdown of how WACC is calculated:

1. A company typically raises capital from two main sources: debt (loans, bonds) and equity (shares, retained earnings).
2. Each source of capital comes with a cost, which reflects the return expected by the providers of that capital.
3. The cost of debt is the interest rate the company pays on its loans or bonds. It represents the cost of borrowing money.
4. The cost of equity is the return required by the shareholders to invest in the company. It represents the cost of raising funds from the stock market.
5. WACC takes into account the proportion of debt and equity used to finance the company. It calculates a weighted average of the costs of these capital sources based on their relative weights.
6. The formula for calculating WACC is: (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity).
7. The weights are determined by the proportion of debt and equity in the company's capital structure. For example, if a company has 70% of its capital from debt and 30% from equity, the weights would be 0.7 and 0.3, respectively.

That’s all pretty good but it really doesn’t explain why it’s important or specifically why it’s important in a leasing context. So, to show we are down with the kids, we asked our friend ChatGPT for help, and this is the answer in a somewhat wordy way:

1. Investment decision-making: WACC is used as a discount rate to evaluate the feasibility of potential investments. It helps determine whether a project or investment will generate returns greater than the cost of capital. If the expected return on an investment is lower than the WACC, it suggests that the investment may not be worthwhile.
2. Capital budgeting: WACC is utilized in capital budgeting decisions, such as determining the optimal capital structure or assessing the cost-effectiveness of different financing options. By comparing the WACC with the expected return on a project, companies can make informed decisions about how to allocate their resources efficiently.
3. Valuation of companies: WACC is also used to estimate the value of a company in financial valuation models like discounted cash flow (DCF) analysis. By discounting the projected cash flows of a company at the WACC, analysts can determine its intrinsic value. This valuation technique is frequently employed in mergers and acquisitions, determining the value of stocks, and other investment decisions.
4. Cost of raising capital: WACC helps companies evaluate the cost of obtaining additional funds through debt or equity financing. It considers both the cost of debt (interest rate) and the cost of equity (required rate of return by investors). By understanding their WACC, companies can determine the most cost-effective way to raise capital for financing new projects or expansions.
5. Performance measurement: WACC is often used as a benchmark for evaluating a company's financial performance. If a company consistently generates returns higher than its WACC, it suggests that it is creating value for its shareholders. Conversely, if the returns fall below the WACC, it may indicate that the company is not generating sufficient returns to cover the cost of capital.

So given we humans need something a little more succinct, we think a summary in a leasing context is along the following lines:

"WACC helps a company decide whether an investment is worth pursuing (such as leasing or buying their equipment) as the WACC factors in the true cost of that funding and in effect the opportunity cost of not using that money elsewhere. The WACC enables a very real comparison by showing different decisions under the same parameters."

So, when someone wants a financial comparison just reach for the WACC…

WACC is crucial in deciding whether to lease or buy, as it helps compare the true cost of financing each option. By factoring in both debt and equity costs, WACC provides a clear benchmark to determine which choice offers better value. Learn more about leasing vs buying here.