What does WACC indicate about a company's expected returns?

WACC, or Weighted Average Cost of Capital, represents the average rate of return a company is expected to pay its security holders to finance its assets, weighted according to the proportion of each source of capital (equity, debt, etc.). It reflects the riskiness of the company because it takes into account the cost of equity, which is influenced by the company's volatility relative to the market, as well as the after-tax cost of debt.

When investors evaluate a company's profitability and potential investment returns, they assess WACC as a benchmark. If a company's return on invested capital exceeds its WACC, it indicates that the company is generating value above its cost of capital, suggesting a favorable risk-return profile. Conversely, if the returns fall below WACC, it may signal underperformance relative to the risks taken.

This interpretation of WACC is crucial for decision-making in capital projects, as it serves as the hurdle rate that investments must exceed for a company to create value. Understanding this relationship between WACC and risk is vital for investors assessing their expected returns on investment.