What is WACC (weighted average cost of capital)?
Key takeaways
by calculating a post-tax average of its capital, such as equity and debt.
especially in discounted cash flow (DCF) analysis.
higher borrowing costs, or a greater reliance on expensive capital sources.
What Is WACC?
Weighted average cost of capital (WACC) is the average rate of return a company must earn on its assets to satisfy its providers of capital (like debt and equity), with each source weighted by its proportion of total capital in financing the business.
What WACC represents
WACC reflects three core elements:
Cost of equity: the return shareholders expect for investing in the company
Cost of debt: the interest rate lenders charge on borrowed capital
Capital structure: the proportion of debt and equity used to fund the business
Together, these components determine the company’s overall cost of capital.
Why it’s called “weighted average”
Each source of financing is weighted based on its proportion of total capital. For example, if a company relies more heavily on equity than debt, equity will have a larger influence on its WACC.
Why WACC is important
Benchmark for investment decisions
In corporate finance theory, projects that generate returns above a company’s WACC are generally viewed as value-creating, while those below it may reduce value.
Role in business valuation
WACC is commonly used as the discount rate in discounted cash flow (DCF) analysis to estimate the present value of future cash flows.
Measuring risk
A higher WACC often indicates higher business or financial risk, while a lower WACC may suggest stable earnings or strong credit quality.
The WACC formula explained
WACC = (E / V × Re) + (D / V × Rd × (1 − Tc))
Formula breakdown:
E = Market value of equity
D = Market value of debt
V = Total value of capital (E + D)
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate
Why taxes matter
Interest payments on debt are often tax-deductible. This creates a tax shield, which lowers the effective cost of debt and reduces WACC compared to equity financing.
Components of WACC (broken down)
Cost of equity (Re)
Equity is generally riskier than debt because shareholders are paid last in bankruptcy. As a result, equity investors generally expect higher returns.
A common method for estimating cost of equity is the Capital Asset Pricing Model (CAPM), which considers market risk and volatility.
Cost of debt (Rd)
The cost of debt reflects the interest rate the company pays on its loans or bonds. It’s often estimated using the yield to maturity on outstanding debt and then adjusted for taxes.
Capital structure (E and D)
Market values are used instead of book values because they better reflect the current economic value of financing.
Leverage affects WACC in complex ways. Moderate debt can lower WACC due to tax benefits, but excessive leverage can increase risk and borrowing costs.
Step-by-step: how to calculate WACC
Step 1: Determine market value of equity
Multiply the company’s share price by the number of shares outstanding.
Step 2: Determine market value of debt
Estimate the market value of outstanding bonds or loans. When market value isn’t available, book value may be used as an approximation.
Step 3: Calculate cost of equity
Using CAPM, estimate cost of equity based on:
Risk-free rate
Beta (stock volatility)
Market risk premium
Step 4: Calculate after-tax cost of debt
Multiply the cost of debt by (1 − corporate tax rate) to account for the tax shield.
Step 5: Apply weights and compute WACC
Insert all values into the WACC formula and calculate the final weighted average cost of capital.
WACC calculation example
Hypothetical example
Using the following hypothetical company’s information:
Market value of equity: $600 million
Market value of debt: $400 million
Cost of equity: 9%
Cost of debt: 5%
Corporate tax rate: 25%
Calculation:
WACC = (600 / 1,000 × 9%) + (400 / 1,000 × 5% × (1 − 0.25))WACC = 5.4% + 1.5%WACC = 6.9%
Interpreting the result
A WACC of 6.9% suggests that investors and lenders collectively expect returns in that range to compensate for risk and capital costs.
What is a “good” WACC?
No universal answer
A “good” WACC depends on factors such as:
Industry characteristics
Business risk
Capital structure
Typical WACC ranges
Stable industries (like utilities) tend to have a lower WACC.
Cyclical or high-growth businesses tend to have a higher WACC.
Early-stage companies may have higher WACC due to elevated risk and limited access to low-cost capital.
Common mistakes when using WACC
Using book values instead of market values
This generally leads to incorrect weighting and distorted results.
Ignoring the tax shield
Failing to adjust for taxes can overstate the true cost of debt.
Applying one WACC to all projects
Projects with different risk profiles may require different discount rates.
Bottom line
WACC is a foundational metric for evaluating investments, valuing businesses, and understanding financial risk. While powerful, it must be calculated carefully and applied thoughtfully — especially when comparing projects with different risk characteristics.
Investments can go down as well as up in value. Valuation models rely on assumptions that may not reflect future performance.
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Frequently asked questions
Why is WACC important?
It represents the minimum return a company must earn to satisfy both investors and lenders.
Is a lower WACC always better?
Not necessarily. A lower WACC may reflect lower perceived risk or cheaper capital, but it can also be influenced by leverage and broader market conditions.
How is WACC used in valuation?
It’s commonly used as the discount rate in discounted cash flow (DCF) models.
Can WACC change over time?
Yes. Changes in interest rates, capital structure, or business risk can affect WACC.
The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.
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