Weighted Average Cost of CapitalWACC
The weighted average cost of capital is the average return a company must pay its lenders and shareholders, weighted by how much of each it uses. It is the usual discount rate in a discounted cash flow valuation.
The weighted average cost of capital blends what a company pays its lenders and what its shareholders expect into one rate. Analysts use it as the hurdle for new projects and as the discount rate in valuation.
- Category
- Fundamentals and Macroeconomics
- Reading time
- 3 min
- Also called
- Cost of capital, Blended cost of capital
- Updated
WACC in plain words
WACC is a company's blended cost of the debt and equity it uses to fund its assets.1
It weights the required return on debt and on equity by how much of each the firm uses.2
Tax rules, and so the after-tax cost of debt, differ by country.
How to calculate WACC
Estimate the cost of equity
Estimate the cost of equity, often with CAPM: the risk-free rate plus a premium for the investment's risk.2
Estimate the cost of debt
Estimate the after-tax cost of debt from the yield debt investors demand.1
Set the tax rate
Estimate the marginal tax rate; tax rules differ by country.1
Choose weights
Choose weights from the long-run target capital structure, which may differ from today's.1
Combine
Weight each cost by its share of total capital and add them.2
Use it
Discount free cash flow to the firm at WACC to estimate firm value.3
Worked examples
Example 1 — Basic WACC
WACC 8%A hypothetical firm is 60% equity at a 10% cost and 40% debt at 5% after tax.
| Equity part | 6.0% |
| Debt part | 2.0% |
| WACC | 8.0% |
Weighting each cost by its share of capital, as Queensland Treasury describes, gives 8%.2
Example 2 — Project hurdle
AcceptA hypothetical project is expected to return 11% against a 8% WACC.
| Expected return | 11% |
| WACC | 8% |
WACC is used by internal decision makers to evaluate capital investments, and this one clears the hurdle.1
Example 3 — Method sensitivity
Range of valuesTwo hypothetical analysts value a firm that is 60% equity and 40% debt at 5% after tax, but estimate the cost of equity at 9% and 11%.
| WACC (analyst A) | 7.4% |
| WACC (analyst B) | 8.6% |
There is no single, “right” method, so valuations should show a range.1
WACC vs cost of equity
| Aspect | WACC | Cost of equity |
|---|---|---|
| Covers | Debt and equity | Equity only |
| Tax effect | Debt cost is after tax | None |
| Used to discount | Free cash flow to the firm | Free cash flow to equity |
| Level | Usually lower | Usually higher |
Where WACC is used
DCF valuation
The discount rate for firm-level cash flows in Fundamental Analysis.
Capital budgeting
A hurdle rate for projects.
Performance review
Compare returns with the cost of capital.
Rate shocks
Higher Interest Rate levels raise WACC.
Advantages and disadvantages
Advantages
- Combines all funding sources.
- Standard in valuation.
- Gives a clear hurdle rate.
- Reflects capital structure.
Disadvantages
- Highly sensitive to assumptions.
- Cost of equity is not observable.
- Tax and accounting rules differ by country.
- Target weights are judgment calls.
Going deeper
Read as far as you need. Each level builds on the one before it.
The idea
Beginner
WACC is the lowest return the firm's investors, lenders and owners together expect.2
Valuation role
Intermediate
The FCFF approach discounts future free cash flow at the weighted average cost of capital.3 Small changes in WACC can move firm value a lot.
Judgment
Advanced
There is no single, “right” method for each cost of capital, and the marginal tax rate must be estimated.1 Tax and accounting rules differ by country, so check local treatment.
Common mistakes
Using book weights blindly
Market or target weights are often better.
Forgetting the tax shield
Debt cost should be after tax.
Mixing currencies
Match the rate to the cash-flow currency.
False precision
Show a range, not one exact figure.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- WACC blends the costs of debt and equity.
- Weights reflect the capital structure.
- Debt cost is taken after tax.
- It is the usual DCF discount rate.
- Tax rules differ by country.
Frequently asked questions
Is a lower WACC better?
Why is debt cheaper?
Does WACC change?
Further learning
- Beta
Input to the cost of equity.
- Leverage
Debt in the mix.
- Interest Rate
Rates and the cost of debt.
- Fundamental Analysis
Where valuation fits.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- CFA Institute. Cost of Capital: Advanced Topics (Refresher Reading) (opens in a new tab) Checked .
- Queensland Treasury. Cost of Capital Principles (opens in a new tab) Checked .
- CFA Institute. Free Cash Flow Valuation (Refresher Reading) (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.