Weighted Average Cost of Capital (WACC)
$$\text{WACC} = \frac{E}{V} \cdot r_e + \frac{D}{V} \cdot r_d \cdot (1 - T)$$
What is Weighted Average Cost of Capital (WACC)?
The Weighted Average Cost of Capital (WACC) is the blended rate of return a company must earn on its total invested capital to satisfy both its debt holders and equity investors. It weights the cost of each capital source - equity and debt - by that source's proportion of the total capital structure. WACC represents the minimum return threshold: any investment earning above WACC creates value; anything below destroys it.
The formula is WACC = (E/V) x Re + (D/V) x Rd x (1 - T), where E is the market value of equity, D is the market value of debt, V = E + D, Re is the required return on equity, Rd is the cost of debt, and T is the corporate tax rate. The (1 - T) adjustment reflects that interest payments are tax-deductible, reducing the effective cost of debt to the company.
Cost of equity is not directly observable - it must be estimated using a model such as CAPM (Re = Rf + Beta x Equity Risk Premium). Cost of debt is the weighted average interest rate on outstanding debt, adjusted downward for the tax shield. Because equity investors bear more risk than lenders, the cost of equity is always higher than the cost of debt.
Weighted Average Cost of Capital (WACC) explained to a beginner
Imagine you borrow $6,000 from a bank at 6% interest and take $4,000 from an investor who wants 10% returns, to fund a $10,000 food stall. The bank's effective cost is 4.5% after tax savings (6% x 75% if you're in a 25% tax bracket). Your blended funding cost is: (60% x 4.5%) + (40% x 10%) = 2.7% + 4.0% = 6.7%. That 6.7% is your WACC - the minimum your food stall must earn on its $10,000 to keep both the bank and the investor satisfied. Earn more than 6.7% and you create value; earn less and you are destroying it.
When to use Weighted Average Cost of Capital (WACC)
Use WACC as the discount rate in discounted cash flow (DCF) valuations and as the benchmark against which ROCE is measured. If ROCE consistently exceeds WACC, the business creates economic value; if ROCE falls below WACC, it destroys value despite showing positive accounting profits. WACC also evaluates individual projects: a project with an expected IRR above WACC adds value; below WACC, it does not.
Worked examples for Weighted Average Cost of Capital (WACC)
This table quickly gives you the overview you need to understand Weighted Average Cost of Capital (WACC) and its most important comparisons.
| Capital source | Amount | Pre-tax cost | After-tax cost | Weight | Weighted cost |
|---|---|---|---|---|---|
| Long-term debt | $6,000,000 | 6.0% | 4.5% (25% tax) | 60% | 2.7% |
| Equity | $4,000,000 | n/a | 10.0% (CAPM) | 40% | 4.0% |
| WACC | $10,000,000 | - | - | 100% | 6.7% |
Common pitfalls
WACC is highly sensitive to the cost of equity, which must be estimated - usually via CAPM - and small changes in the equity risk premium or beta assumption can shift WACC by 200-300 basis points, materially changing valuations. A second common error is using book values rather than market values to calculate weights: if a company's equity trades far above book value, using book values understates the equity weight and overstates the debt weight, producing a misleadingly low WACC. Always use current market prices for the weights.
Frequently asked questions about Weighted Average Cost of Capital (WACC)
What is the difference between WACC and cost of equity?
Cost of equity is the return equity investors require (estimated via CAPM or dividend discount models) and covers only the equity portion of the capital structure. WACC blends cost of equity and after-tax cost of debt, weighted by each source's proportion. Because debt is cheaper than equity and generates a tax shield, WACC is always lower than the standalone cost of equity.
Why is the cost of debt multiplied by (1 - tax rate) in the WACC formula?
Interest on debt is tax-deductible in most jurisdictions. A company with a 25% tax rate paying 6% interest effectively pays only 4.5% after the tax saving - the government subsidizes part of the interest cost. The (1 - T) adjustment captures this benefit, so WACC uses the true after-tax cost of debt rather than the contractual rate.
Can WACC change over time?
Yes. WACC changes whenever market conditions shift: rising interest rates increase the cost of debt; changes in stock price or market risk alter the cost of equity; and refinancing or capital raises shift the debt and equity weights. Companies typically recalculate WACC annually and more frequently during major capital structure changes or valuation work.
Quiz: how well do you know WACC?
1. What does WACC represent?
2. A company has $6M of debt at a 4.5% after-tax cost and $4M of equity at a 10% cost. What is the WACC?
3. Why is the cost of debt multiplied by (1 - tax rate) in the WACC formula?
4. According to the pitfalls section, what type of values should be used to weight debt and equity in WACC?
5. According to the definition, when does a business create economic value?