WACC: Weighted Average Cost of Capital
WACC, or weighted average cost of capital, is the average return a company must pay its lenders and shareholders. Each source of money is weighted by how much of it the company uses. Debt gets a tax adjustment because interest is usually tax-deductible.
What you will learn
- What cost of capital means for debt and for equity
- The WACC formula and what each piece stands for
- Why the cost of debt is multiplied by (1 − tax rate)
- How to find the weights of debt and equity
- Where CAPM fits in as the cost of equity
The formula
- E
- market value of equity
- D
- market value of debt
- V
- E + D, total capital
- r_e
- cost of equity, often from CAPM
- r_d
- pre-tax cost of debt
- T
- corporate tax rate
Worked example
A company has $600 of equity and $400 of debt. Cost of equity is 10%, pre-tax cost of debt is 6%, and the tax rate is 25%. What is its WACC?
- Weights: E ÷ V = 600 ÷ 1,000 = 60%; D ÷ V = 400 ÷ 1,000 = 40%
- After-tax cost of debt = 6% × (1 − 0.25) = 4.5%
- Equity part = 60% × 10% = 6.0%
- Debt part = 40% × 4.5% = 1.8%
- WACC = 6.0% + 1.8% = 7.8%
Answer: WACC = 7.8%
Common questions
What is the WACC formula?
WACC = (E ÷ V) × cost of equity + (D ÷ V) × cost of debt × (1 − tax rate). E and D are the market values of equity and debt, and V is their total. It gives the blended return the company must earn for all its investors.
Why is the cost of debt multiplied by (1 − tax rate)?
Interest payments are usually tax-deductible, so each dollar of interest lowers the company's tax bill. The real, after-tax cost of borrowing is therefore smaller than the stated interest rate. Equity returns get no such deduction.
Should WACC use market values or book values?
Market values are preferred because they reflect what investors would pay for the company's debt and equity today. Book values are used when market values are not available, but exam questions usually tell you which to use.
What is WACC used for?
WACC is the usual discount rate for a company's projects and free cash flows. If a project's return is above WACC, it creates value for investors; below WACC, it destroys value. It is a key input in NPV and company valuation.