Weighted average cost of capital

Before you rely on it

What to check

Confirm the weights use market values, and that the cost of debt is stated after tax where interest is deductible.

The common error

Where people go wrong with weighted average cost of capital

Using book weights. Book and market values of equity can differ enormously, and the resulting WACC sends the whole valuation off in one direction.

Worked through

Weighted average cost of capital in plain numbers

A company is financed with $600 million of equity and $400 million of debt. Investors require 10% on the equity. The debt costs 6% before tax, and the tax rate is 25%, so its after-tax cost is 4.5%; the weights are 60% and 40%. WACC is 0.60 × 10% + 0.40 × 4.5%, which is 7.8%; a project must earn more than 7.8% to add value, if it carries the same risk as the business. Shift the mix to 50/50 and the WACC falls to 7.25%, because debt is cheaper. But more debt makes the equity riskier, and investors will ask for more than 10%, so the saving is not free.

Easily confused

Weighted average cost of capital and its neighbours

WACC is not the interest rate on debt or the cost of equity alone; it blends the two, weighted by their share of financing, after the tax shield on interest. It differs from the required return on a single project, which depends on that project's risk; it also differs from the discount rate used for a specific cash flow if that flow is riskier or safer than the firm overall. Weights can use market values or book values, and analysts prefer market values. Cost of equity is usually estimated with a model such as CAPM.

In real decisions

Where weighted average cost of capital turns up

Companies use WACC as the hurdle rate for capital projects. Analysts use it to discount free cash flows in valuation. Boards use it to evaluate acquisitions. Regulators use versions of it to set allowed returns for utilities. Changing capital structure, refinancing debt or a shift in market rates all move it; a calculator combines the inputs and shows the effect of changing weights or costs.

Know the edges

Where weighted average cost of capital stops being reliable

Inputs are estimates, particularly the cost of equity, and small changes in them move the result; the weights change as market values move. Using a single rate for all projects ignores differences in risk. Tax rules and financing costs vary. Use WACC as a starting point and adjust for project risk.

Quick answers

What people ask about weighted average cost of capital

What weights should I use? Use the market values of equity and debt where possible. Book values can be far from what the market would pay.

Why use the after-tax cost of debt? Interest is often tax deductible, which lowers the true cost. The adjustment multiplies the interest rate by one minus the tax rate.

Should every project use the company's WACC? Only if it carries similar risk. Riskier projects need a higher rate, and safer ones a lower rate.