WACC explained: formula, cost of equity and cost of debt

WACC, short for weighted average cost of capital, is the average rate a company must earn to satisfy everyone who funds it: lenders who expect interest and shareholders who expect a return for taking risk. It is the standard yardstick for judging whether a business creates value and the usual discount rate for valuing a company's cash flows.

What is WACC in simple terms?

WACC is the one percentage that says what it costs a company, on average, to fund itself. Lenders want interest and shareholders want a return, and WACC blends the two in proportion to how much of each the company uses. It is also called the cost of capital or, from the investor's side, the required return on the business as a whole. A company creates value only when its investments earn more than its WACC, and a discounted cash flow model uses the same rate to turn future cash flows into a value today.

The idea behind the cost of capital

Capital is not free. Borrowing has an explicit price in the form of interest. Equity has an implicit price: investors could have put the same money elsewhere, so they require a return that compensates for the risk of owning the shares. The cost of capital combines the two, weighted by how much of each the company uses.

What is the WACC formula?

In words, WACC is the equity share of funding times the cost of equity, plus the debt share times the after-tax cost of debt. To apply it:

1. Split the company's capital into equity and debt, using market values, to get the two weights.
2. Estimate the cost of equity, usually with the capital asset pricing model.
3. Take the interest rate on the company's borrowing and reduce it for the tax saving to get the after-tax cost of debt.
4. Multiply each cost by its weight and add the two results.

The next section writes this out with symbols and defines each one.

The formula

WACC = E/(D+E) x Re + D/(D+E) x Rd x (1 - T)

The cost of debt is multiplied by (1 - T) because interest is generally tax-deductible, so the government effectively shares the cost. Dividends and share buybacks are not deductible, so the cost of equity gets no such adjustment. If a company has preferred stock, it is added as a third term with its own weight and cost.

Estimating the cost of equity

Unlike debt, the cost of equity cannot be read from a contract. The standard approach is the capital asset pricing model:

Re = Risk-free rate + Beta x Equity risk premium

The risk-free rate is typically the yield on long-term government bonds, beta measures how strongly the stock tends to move with the overall market, and the equity risk premium is the extra return investors require from stocks in general over a risk-free investment. The article on the discount rate and CAPM goes further. StocksXray uses Damodaran datasets for betas and the equity risk premium.

How do you calculate the cost of equity and cost of debt for WACC?

Cost of equity. Use CAPM as shown above: the risk-free rate plus beta times the equity risk premium. Some analysts add a size premium for small companies, covered below.

Cost of debt. Use the interest rate the company would pay to borrow today, not the coupon on debt it issued years ago. Good sources are the yield on the company's traded bonds, the rate on its most recent loan or, as a rough check, its interest expense divided by its average debt. Then multiply by (1 - tax rate) to get the after-tax cost of debt.

Weights. Use the market value of equity (share price times shares outstanding) and the market value of debt. When a company's debt does not trade, the book value of debt on the balance sheet is a common approximation, though it is less accurate when interest rates have moved a lot since the debt was issued.

Example (illustrative numbers)

A company is financed 70% by equity and 30% by debt. The risk-free rate is 4%, beta is 1.0 and the equity risk premium is 5%. The company's borrowing costs 5% and its tax rate is 25%.

Re = 4% + 1.0 x 5% = 9.0%
After-tax cost of debt = 5% x (1 - 0.25) = 3.75%

WACC = 0.70 x 9.0% + 0.30 x 3.75%
     = 6.30% + 1.125%
     = 7.4% (rounded)

To create value, the company's projects must on average earn more than about 7.4% a year on the capital invested. Compare this with the company's ROIC: an ROIC of 12% would mean a healthy spread, while an ROIC of 6% would mean the business is not earning its cost of capital.

Why WACC matters so much in valuation

In a discounted cash flow model, future cash flows are converted into today's dollars using the WACC. A higher rate shrinks the present value of distant cash flows, and because much of a company's value typically sits far in the future, valuation is highly sensitive to this one number.

Moving from 6% to 10% cuts the present value of that distant cash flow by almost a third. A model that appears precise can swing widely on small changes in assumptions. This sensitivity is also one reason fair value is better expressed as a range than as a single number.

What is a good WACC?

There is no single good WACC, because it reflects risk. A lower WACC is not better in itself: it usually means the business is seen as safer or that interest rates are low, not that it is better run. What matters is the gap between the return the business earns and its WACC. A company creates value when its ROIC is above its WACC, and the wider the gap the better. To judge a figure, compare it with companies in the same industry, with the company's own history and with the level of interest rates, since the risk-free rate feeds every cost of capital. Steady, defensive businesses tend to have lower WACCs than cyclical or early-stage ones, but that is a tendency, not a rule.

Is the size premium part of WACC?

Not in the basic formula. Some analysts add a size premium to the cost of equity of small companies, on the argument that small companies have tended to demand higher returns than CAPM alone predicts. If they do, the extra return raises the cost of equity and, through it, WACC by the equity weight times the premium. Illustrative example: with the 70% equity weight used above, a made-up 2-point size premium would lift the cost of equity from 9.0% to 11.0% and WACC from about 7.4% to about 8.8%. Whether to add a size premium, and how large it should be, is debated, so treat it as a judgement and state it openly when you use it. The equity risk premium itself is a market-wide figure and does not include it.

WACC vs discount rate: are they the same?

Often, but not always. A discount rate is the rate used to bring any future cash flow back to today's value, and it should match the risk of that cash flow. WACC is the discount rate for cash flows that belong to everyone who funds the company, such as free cash flow to the firm in a DCF. Cash flows that belong only to shareholders, such as dividends or free cash flow to equity, are discounted at the cost of equity instead. So WACC is one kind of discount rate, and "cost of capital" is the usual everyday name for it. See discounted cash flow basics and the discount rate and CAPM.

Common mistakes and limits

Using book values for the weights. The weights should reflect market values of capital, not the accounting values on the balance sheet. A company with a high stock price and modest debt may have a much lower share of debt in market terms than book terms suggest.

Believing the output is precise. Beta is an estimate based on historical price movements and can vary with the time period and index chosen. The equity risk premium is debated by practitioners and the choice of risk-free rate matters. Treat WACC as a reasonable range of a point or two, not as a measured fact.

Using one rate for everything. A company's WACC reflects its overall average risk. A new venture in an unfamiliar, riskier market should be judged against a higher rate than the company's core business.

Assuming cheap debt makes everything cheaper. Adding debt lowers WACC at first because debt is cheaper than equity, but more debt also makes the equity riskier and raises the cost of both. There is no free lunch in simply borrowing more.

Ignoring changes over time. Interest rates, risk premiums and the company's capital structure all move. A WACC computed in one environment may not be appropriate in another.

Using the wrong tax rate. Using the marginal tax rate on interest deductions is the principle, but effective rates are often used in practice. Be aware of the choice.

Where to see it on StocksXray

The fair value estimate includes a ten-year DCF as one of its three models, and the cost of capital is a central input to any such model. The site's methodology page explains how the models are blended and why the result is presented as a range, with typical model error around 40%. The same page lists the inputs: the risk-free rate is the US 10-year Treasury yield, and betas and the equity risk premium come from Aswath Damodaran's public datasets, refreshed each January. Each stock page, such as Microsoft, shows the resulting fair value band next to the price.

Frequently asked questions

What does WACC stand for? WACC stands for weighted average cost of capital. It is "weighted" because the cost of each source of funding, debt and equity, is multiplied by that source's share of the company's total funding before the results are added.

How do you calculate WACC? Multiply the cost of equity by the equity share of funding, multiply the after-tax cost of debt by the debt share, and add the two. The cost of equity usually comes from CAPM, and the cost of debt from the interest rate the company pays on new borrowing, reduced by the tax rate. The worked example above gives about 7.4% on illustrative inputs.

Is a lower WACC better? For the company, a lower cost of capital makes it easier for projects to clear the hurdle, and it raises the value a DCF gives to the same cash flows. But a low WACC often reflects lower risk or low interest rates rather than better performance, so compare it with the return the business actually earns, not on its own.

What is the difference between WACC and the cost of equity? The cost of equity is the return shareholders require. WACC blends it with the after-tax cost of debt. For a company with no debt the two are the same. For a company that uses debt, WACC is usually lower than the cost of equity, because debt is cheaper.

Why is debt cheaper than equity in the WACC formula? Lenders are paid before shareholders and have a legal claim on repayment, so they accept a lower return, and interest is generally tax-deductible, which the (1 - T) term reflects. Borrowing more does not make capital free, because extra debt makes the equity riskier and raises its cost.

Is WACC the same as a capitalization rate? Not exactly. In a growing perpetuity, the capitalization rate is the discount rate minus the growth rate, so for firm-level cash flows it is WACC minus growth. In real estate, a cap rate is a property's net operating income divided by its value, which is a different measure. See terminal value.

Does WACC change over time? Yes. Interest rates, the equity risk premium, the company's beta and its mix of debt and equity all move, so WACC changes with them. A WACC worked out in one year may not suit another.

Key takeaways

• WACC is the blended cost of a company's debt and equity, weighted by their market-value shares, with debt adjusted for the tax deduction on interest.
• The cost of equity is usually estimated with CAPM from the risk-free rate, beta and the equity risk premium.
• A business creates value only when its return on invested capital exceeds WACC.
• Small changes in WACC produce large changes in DCF valuation, so treat it as an estimate with a range.
• Use market values for the weights and match the rate to the risk of what is being valued.