A company raises money from two broad groups of investors: shareholders, who own the equity, and lenders, who provide debt. Each group expects a return for the risk it takes. The weighted average cost of capital (WACC) combines those required returns into a single percentage, weighted by how much of the firm’s financing each group provides. It is the minimum average return a company must earn on its existing assets to satisfy all its investors, and it is widely used as the discount rate in NPV analysis and DCF valuation.
What you will learn
- Explain what WACC represents and why it matters
- Calculate WACC from its components
- Understand why the cost of debt is taken after tax and why market values are used
- Recognise when a project needs a different discount rate
The WACC formula
Weighted average cost of capital
WACC = (E ÷ V) × Re + (D ÷ V) × Rd × (1 − T)
E = market value of equity, D = market value of debt, V = E + D, Re = cost of equity, Rd = pre-tax cost of debt, T = corporate tax rate. If the company has preferred shares, add a third term: (P ÷ V) × Rp.
The components
Cost of equity (Re)
Equity has no contractual interest rate, so its cost must be estimated from what investors require. The two common approaches are the capital asset pricing model (CAPM) — risk-free rate plus beta times the market risk premium — and the dividend growth model. Both are explained in detail in cost of equity and cost of debt. Equity is riskier than debt for investors, so its cost is higher.
Cost of debt (Rd)
The pre-tax cost of debt is the rate the company would pay to borrow today: the yield to maturity on its bonds, or the current rate on new bank loans of similar terms. Historic coupon rates are not appropriate if market rates have moved.
Why debt is after tax
In most tax systems, interest is deductible from taxable profit, so each unit of interest paid reduces the tax bill. The effective cost of debt is therefore Rd × (1 − T). If a company pays 10% interest and its tax rate is 25%, the after-tax cost is 7.5%. The tax saving is called the interest tax shield. It only applies if the company actually has taxable profits to offset.
Weights: market values, not book values
The weights should reflect the market values of equity and debt, because they represent what investors would have to pay today to acquire the firm’s capital. For equity, use market capitalisation (share price × number of shares). For debt, use the market value of bonds where available; for bank loans, book value is usually an acceptable approximation. Many analysts use a target capital structure if the company plans to move towards it.
Worked example: calculating WACC
A company has equity worth 600,000 at market value and debt worth 400,000. Its cost of equity is 12%, its pre-tax cost of debt is 8% and its tax rate is 25% (illustrative figures).
- Total capital V = 600,000 + 400,000 = 1,000,000. Weights: E/V = 60%, D/V = 40%.
- After-tax cost of debt: 8% × (1 − 0.25) = 6.0%.
- Equity component: 0.60 × 12% = 7.2%.
- Debt component: 0.40 × 6.0% = 2.4%.
- WACC = 7.2% + 2.4% = 9.6%.
The WACC calculator lets you test different weights and rates.
Where the 9.6% comes from
Show the data
| Item | Share |
|---|---|
| Equity component (7.2 pts) | 75.0% |
| After-tax debt component (2.4 pts) | 25.0% |
Using WACC as a discount rate
WACC is the right discount rate for a project when two conditions hold:
- The project has the same business risk as the company’s existing operations.
- The project is financed in a way that keeps the company’s capital structure broadly unchanged.
A project that meets both, with expected cash flows discounted at 9.6%, is worth undertaking if its NPV is positive.
When WACC is the wrong rate
- Different risk: a utility company entering a risky technology venture should not use its low WACC. A common approach is to estimate the cost of capital of companies already in that business (a "pure play") and adjust for financing.
- Different financing: a project financed with specific subsidised debt, or one that changes the firm’s leverage significantly, may need the adjusted present value approach instead.
- Divisions with different risk: using one company-wide WACC tends to over-invest in risky divisions (whose true cost of capital is higher) and under-invest in safe ones.
What drives WACC
| Change | Typical effect on WACC |
|---|---|
| Interest rates rise | Up — both Rd and the risk-free rate in Re rise |
| Company becomes riskier (higher beta) | Up — Re rises |
| Tax rate rises | Down slightly — the debt tax shield grows |
| More debt in the mix | Down at first (cheaper debt, tax shield), then up as financial risk raises both Re and Rd |
That last point is the subject of capital structure theory: adding cheap debt does not lower WACC indefinitely, because equity holders demand more as leverage rises, and lenders eventually charge more too.
Limitations
- Estimation error: the cost of equity cannot be observed and is sensitive to the beta, risk-free rate and market risk premium chosen. It is good practice to test NPV at a range of rates.
- Changing structure: WACC assumes constant weights; in reality leverage changes over time.
- One rate for all horizons: WACC is usually applied to all future years, even though risk and rates may change.
- Emerging market adjustments: analysts sometimes add country risk premiums, which involves further judgement.
Common mistakes
- Using book values of equity, which can differ greatly from market values.
- Forgetting the tax adjustment on debt, or applying it when the company has no taxable profit.
- Using the coupon on old bonds instead of the current market cost of debt.
- Applying the company WACC to projects of very different risk.
- Treating debt as "free" because it is cheaper than equity, ignoring the extra risk it creates.
Key terms
- WACC — the weighted average of the costs of equity and after-tax debt.
- Cost of equity — the return shareholders require for the risk they bear.
- Cost of debt — the current interest rate the company would pay on borrowing.
- Interest tax shield — the tax saved because interest is deductible.
- Capital structure — the mix of debt and equity used to finance the firm.
Frequently asked questions
Why is the cost of equity higher than the cost of debt?
Shareholders are paid only after lenders and have no guaranteed return, so they bear more risk and require a higher expected return.
Should I use the WACC of my company to value a target company?
No. Use a discount rate that reflects the target’s own business risk and expected financing.
Can WACC be lower than the risk-free rate?
In normal conditions no, because both equity and debt investors require at least compensation for the time value of money and some risk.
Key takeaways
- WACC = (E/V) × Re + (D/V) × Rd × (1 − T), using market values.
- Debt is taken after tax because interest is generally tax-deductible.
- WACC is the right discount rate only for projects with the firm’s average risk and financing.
- Estimates are uncertain, so test decisions over a range of rates.