What is the role of cost of equity in WACC calculation?

The role of cost of equity in the Weighted Average Cost of Capital (WACC) calculation is vital, as it represents the return that equity investors expect for investing in a company's equity. This cost is not fixed; it is influenced by several factors, including the risk associated with the company’s equity and the overall market conditions. In the WACC formula, the cost of equity is calculated using models like the Capital Asset Pricing Model (CAPM), which considers the risk-free rate, the equity beta (a measure of risk), and the expected market return.

Incorporating the cost of equity is crucial because WACC is used to weigh the cost of all capital sources—equity and debt—when assessing investment decisions, valuation, and performance metrics. An accurate representation of the cost of equity ensures that the overall rate reflects the expected compensation required by investors for the risks they take by holding the company's stock. This understanding is essential for making informed financial decisions and strategic planning within the company.