WACC: meaning, formula and a simple example

Companies raise money from lenders and from shareholders, and both expect a return. WACC, the weighted average cost of capital, combines these into one rate. This page explains what WACC means, how it is calculated and how it is used.

Quick answer

WACC, the weighted average cost of capital, is the average rate of return a company must pay to all its providers of capital, weighted by how much each provides. It mixes the cost of equity and the after-tax cost of debt. WACC is often used as the discount rate in a DCF valuation and as a hurdle rate: projects should earn more than WACC to add value.

Key takeaways

• It blends the cost of equity and the cost of debt.
• Each cost is weighted by its share of total capital.
• Debt cost is taken after tax because interest is tax-deductible.
• It is a common discount rate in DCF valuation.
• Returns above WACC create value, below it destroy value.

What does WACC mean?

A company's capital usually comes from two sources: debt, such as loans and bonds, and equity, which is shareholders' money. Lenders expect interest, and shareholders expect a return through dividends and share price growth.

The weighted average cost of capital adds these expected returns together, giving each a weight based on how much of the company's capital it makes up. The result is the overall cost of funding the business.

The formula

WACC = (E / V) x Re + (D / V) x Rd x (1 minus Tax rate). Here, E is the market value of equity, D is the value of debt, V is E plus D, Re is the cost of equity and Rd is the cost of debt before tax.

Debt cost is adjusted for tax because interest is usually a tax-deductible expense. This makes debt cheaper for the company than its headline interest rate suggests.

A simple example

After-tax cost of debt = 9 percent x (1 minus 0.25) = 6.75 percent. WACC = 0.60 x 14 percent + 0.40 x 6.75 percent = 8.4 percent + 2.7 percent = 11.1 percent. These numbers are only for illustration.

How is it used?

In a discounted cash flow valuation of the whole business, the free cash flows are discounted at WACC to find enterprise value. A higher rate gives a lower value, and a lower rate gives a higher value.

Companies also use this rate as a hurdle. If a new project is expected to earn a return above the cost of capital, it may add value for shareholders. Investors compare a company's return on capital, such as ROCE, with its cost of capital for the same reason.

Points to be careful about

The cost of equity is not directly visible and is usually estimated with models like CAPM, so different analysts may get different answers. Weights should ideally use market values, not just book values.

In short, WACC is the blended cost of a company's money. It is a central number in valuation, but it rests on estimates and should be tested with a range of inputs.

Frequently Asked Questions