Weighted Average Cost of Equity (WACE)
Candlefocus EditorBy taking into account both the types and amounts of equity that are held by a company, the weighted average cost of equity gives a more precise picture of the overall risk and return of the portfolio than the traditional arithmetic average cost of equity could achieve. This is because the arithmetic average does not take into account the level of risk in each security held. For example, a company with an equal percentage of Small Cap stock and Large Cap stock would have the same average cost of equity in an arithmetic average, but if the Small Cap has a higher level of risk than the Large Cap stock, the average return on Small Cap stock would be higher than the average return on the whole portfolio.
The formula used to calculate a weighted average cost of equity is relatively simple. It involves multiplying the cost of the equity by the amount invested in each security within the portfolio to obtain the weighted average cost. Then this sum of all weighted averages is used as a single figure to represent the overall cost of equity.
The weighted average cost of equity calculation is often used when comparing investment opportunities, or when valuing companies and their assets. It is also used in capital budgeting decisions, such as deciding where to allocate funds and in tracking the performance of equity investments over time.
In conclusion, the weighted average cost of equity is a useful tool for businesses seeking to optimize their cost-efficiency and risk-return profile. By taking into account both the quantity and type of equity held, the weighted cost of equity more accurately reflects the portfolio’s overall risk and return. Furthermore, it is an important factor when assessing new investment opportunities and valuing companies.