WACC stands for weighted average cost of capital, a concept used in the corporate financing decision-making process. The weight components refer to the amount of debt, market value of preferred stock and market value of common equity that are the mix of a company's funding capital. The relative weights of different sources of capital represent a company's capital structure. Management strives to make best use of each funding source to find the optimal capital structure that produces the minimum total cost of capital to maximize shareholders value.
Weighted Average Cost of Capital
Both a capital's weight and its cost affect WACC. The WACC formula is expressed as the sum of each capital's weight multiplied by its cost. A change in the cost of debt, preferred stock or common equity, as well as any adjustment in the relative amount of each type of capital as employed by the company can lead to an increase or decrease in the company's WACC. Depending on the relative rate of return that lenders, preferred shareholders and common equity investors require, a company may structure its financing accordingly to obtain the lowest average cost of capital possible.
Preferred Stock Vs. Debt
Cost of debt usually is lower than cost of preferred stock, because, unlike preferred shareholders, debt holders have prior claims on company cash distributions, thus bearing less risk and requiring lower rate of return. All else being equal, it may seem that a company could benefit from savings on financing cost if it uses more of the cheaper debt than preferred stock. But sometimes during a period of operational difficulties, a company may issue more preferred stock instead of debt to relieve itself of the financial pressure applied by the continued interest payments and any repaying of debt. Therefore, the issuing of more expensive preferred stock may increase WACC in the short term.
Preferred Stock Vs. Common Equity
Issuing preferred stock normally is less expensive than issuing common equity, because common shareholders are the last in line for company earnings, having the ultimate responsibility for a company's failure and thus requiring higher rate of return. But using the less expensive preferred stock instead of common equity is not always an easy choice, because a company would then be obligated to pay preferred dividends. Even though a company can suspend the dividends when necessary, it must promise to make that up later. If a company decides to issue more preferred stock than common equity, the issuance can potentially lower the company's WACC at the time.
The Net Effect
Depending on how the relative use of debt or common equity is affected, issuing preferred stock may increase and decrease a company's WACC in the immediate term. But the longer term net effect may be uncertain, because many other factors do not remain constant following the change in capital structure. A decrease in debt-to-equity ratio by using more preferred stock could have a positive effect on the company over the long run. Less financial leverage can reduce overall risk and may cause WACC to go down over time. On the other hand, the increased use of preferred stock relative to common equity might expose a company to higher financial risk because of its preferred-dividend obligation. Therefore, the immediate benefit of lowering WACC from issuing preferred stock may disappear over time, and WACC may go up gradually.