How it works
WACC blends two costs. The cost of equity is the return shareholders expect, often estimated with CAPM. The cost of debt is the interest the business pays, reduced by the tax saving, because interest is usually tax-deductible. Each cost is weighted by its share of total funding, ideally at market values.
A business with more cheap debt can have a lower WACC, but more debt also increases risk, which raises the cost of equity. The best structure balances the two.
WACC = [E ÷ (D + E)] × Cost of equity + [D ÷ (D + E)] × Cost of debt × (1 − tax rate)
A simple example
How it is used
- As the discount rate in a DCF.
- As the minimum return a project must earn to create value.
- To compare the cost of different funding mixes.
Common mistakes
- Using book values when market values are available.
- Using a cost of debt that is not the current market rate.
- Mixing a WACC in one currency with cash flows in another.
- Using today's funding mix when the target mix will be different.
Questions
What is a good WACC?
There is no single good level. WACC depends on the industry, the country and the risk. Stable utilities usually have a lower WACC than early-stage technology companies.
Is WACC the same as the discount rate?
In a DCF of the whole business it is usually used as the discount rate. Valuing only the cash flows to shareholders uses the cost of equity instead.
Keep learning
- What is CAPM and the cost of equity?
- What is beta in finance?
- What is a DCF (discounted cash flow)?
- Guide: Business valuation
- Cost of equity and WACC calculator
- Damodaran: costs of capital by sector
- Glossary: Weighted average cost of capital (WACC)
- Glossary: Cost of equity
- Glossary: Capital asset pricing model (CAPM)
- Glossary: Discount rate