Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC) measures the average rate a company must pay to finance its operations through debt and equity. It’s a central tool for corporate finance and investing: companies use it as a hurdle/discount rate for projects and acquisitions, and investors use it to assess whether expected returns compensate for risk.

Key takeaways

• WACC combines the cost of equity and the after‑tax cost of debt, weighted by their market values.
• It is commonly used as a discount rate in discounted cash flow (DCF) analysis and as a benchmark for investment decisions.
• Calculating WACC requires estimates (especially cost of equity), so results are sensitive to assumptions and should be used alongside other metrics.

The formula

WACC = (E / V) × Re + (D / V) × Rd × (1 − Tc)

Where:
* E = market value of equity
D = market value of debt
V = E + D (total market value of financing)
Re = cost of equity
Rd = cost of debt (pre‑tax)
* Tc = corporate tax rate

E/V and D/V are the proportions (weights) of equity and debt financing. The debt term is multiplied by (1 − Tc) because interest expense is tax deductible, lowering the net cost of debt.

Components

Cost of equity (Re)

Cost of equity is the return shareholders require. It’s not directly observable and is typically estimated with models such as the Capital Asset Pricing Model (CAPM):
Re = Risk‑free rate + Beta × Equity risk premium

Because it relies on historical inputs and estimates (beta, risk premium), the cost of equity can vary across analysts.

Cost of debt (Rd)

Cost of debt is the effective interest rate a company pays on its borrowings. For public companies, use the yield to maturity on outstanding debt or the market interest rates implied by credit spreads. For private firms, approximate using credit ratings plus a spread over a risk‑free rate. Use the after‑tax cost in WACC: Rd × (1 − Tc).

Weights (E and D)

Use market values (market capitalization for equity and market value of debt) rather than accounting/book values whenever possible, because the market values reflect current investor expectations.

Example

A company has $4,000,000 of equity and $1,000,000 of debt (V = $5,000,000). Assume Re = 10%, Rd = 5%, and Tc = 25%.

• E/V = 4,000,000 / 5,000,000 = 0.8
• D/V = 1,000,000 / 5,000,000 = 0.2
• Weighted equity = 0.8 × 0.10 = 0.08
• Weighted debt = 0.2 × 0.05 × (1 − 0.25) = 0.0075

WACC = 0.08 + 0.0075 = 0.0875 = 8.75%

WACC versus Required Rate of Return (RRR)

The required rate of return (RRR) is the minimum return an investor demands for investing in a security. WACC can serve as a firm‑level RRR because it reflects the blended return required by both debt and equity providers given the company’s capital structure. However, equity investors often require a return higher than WACC, since WACC is an average across capital providers.

Limitations and challenges

• Sensitive to inputs: small changes in beta, risk premium, or tax rate can meaningfully change WACC.
• Cost of equity is an estimate and can vary across models and analysts.
• Complex capital structures (multiple debt instruments, preferred equity, convertible securities) require careful treatment.
• Market conditions and firm lifecycle (startup vs. mature firm) affect comparability across companies.

Because of these limitations, WACC should be used alongside other valuation and risk measures.

What is a “good” WACC?

There is no universal “good” WACC. Lower WACC generally indicates cheaper capital and/or lower perceived risk, but acceptable levels depend on industry norms, company maturity, and growth prospects. Compare a company’s WACC to peer averages and to the expected returns of prospective projects.

Related concepts

Capital structure

The mix of debt and equity a company uses to finance itself. The chosen structure affects WACC, financial risk, and flexibility.

Debt‑to‑equity ratio

A common leverage metric comparing a company’s liabilities to shareholder equity. Higher ratios typically imply greater financial risk and can increase the company’s cost of capital.

Practical tips

• Use market values, not book values, for weights.
• Use an appropriate risk‑free rate and matching maturity for the firm’s cash flows when estimating Re.
• Reflect the company’s current credit spreads and actual debt yields for Rd.
• Test WACC sensitivity to key inputs and consider scenario analysis.
• Combine WACC with other metrics (growth rates, ROIC, comparable multiples) for investment decisions.

Conclusion

WACC is an essential tool for valuing companies and evaluating investment opportunities because it captures the blended cost of financing from equity and debt. Its usefulness depends on careful estimation and sensible interpretation alongside other financial analyses.