WACC is the weighted average cost of capital. It is the minimum return that a company must earn to satisfy all the stakeholders (viz lenders and shareholders) who give money to the company.

Lenders demand interest for the loans that they give to the company. The interest rate that they demand is equal to Risk free rate (ie rate on government securities) plus premium for risk of lending to the company. This is why banks charge lower rate to AAA borrowers and higher rate to lower rated borrowers.

Shareholders demand higher return than lenders for the equity capital that they give to the company to compensate for the equity risk they bear.

This risk is calculated as sum of ‘risk of equity mkt as a whole called equity risk premium or ERP’ and ‘risk of the specific company called Beta’.

ERP is taken as equal to past returns of the equity markets.

Beta is calculated as volatility of the price movement of a specific company compared to the market as a whole. Hence if a stock is 20% more volatile, then its Beta is equal to 1.2

#### WACC is calculated as below:

(Weight of Debt) x (Post tax cost of debt) + (Weight of Equity) x (Cost of Equity)

#### Cost of Equity is calculated as below:-

Risk free rate + (ERP x Beta)

Hence if the Risk free rate is 8%, Equity risk premium is 4% and Beta is 1.2, then equity shareholders would want 8% + (4% x 1.2) ie 12.8% return from the company.

Hence the cost of equity for this company would be 12.8%.

A company that earns more than WACC is said to be generating alpha.