WACC Explained: Formula, Cost of Capital, and Worked Examples

The weighted average cost of capital, WACC, is the average rate a company pays for the money it uses, weighted by how much of that money comes from shareholders and how much from lenders. It is the hurdle rate for investment decisions: a project that earns more than the WACC creates value, and a project that earns less destroys it. It is also one of the most misused numbers in finance, because each of its inputs is an estimate, and small changes in the estimates move the answer by more than most projects’ margins. This guide explains the formula, where each input comes from, two worked examples, and the limits that keep it honest. It uses no live market data: every figure is an illustration, labelled as one.

What WACC measures

A company is financed by a mix of equity — money from shareholders — and debt — money borrowed from lenders and bondholders. Each source has a cost: shareholders expect a return for the risk they take, and lenders charge interest. WACC blends those costs into one rate, weighted by the share of each source in the company’s capital. It answers a simple question: what return must the company’s assets earn, on average, to satisfy both groups?

The weights are the market values of equity and debt divided by their total. Market value matters because it is what the capital is actually worth today, and what a new investor would pay. Book values — the historical figures on the balance sheet — can be far from market values, especially for equity, and weighting by them gives a WACC that describes the past, not the capital the company uses now. For a private company with no traded share price, the market value of equity must be estimated, which is one more estimate in a calculation full of them.

WACC is a nominal, after-tax rate, usually expressed annually. Nominal means it includes expected inflation, so it must be compared with nominal cash flows — cash flows that also include inflation. Comparing a nominal WACC with real, inflation-stripped cash flows, or the reverse, is a common and costly error.

Try the method on your own figures with the WACC Calculator.

The formula, piece by piece

The formula has two terms, one for each source of capital. The equity term is the weight of equity times the cost of equity. The debt term is the weight of debt times the cost of debt, reduced by the tax rate, because interest payments are tax-deductible and the tax saved is a real reduction in the cost of borrowing.

Worked example: a company financed 60% by equity and 40% by debt. The cost of equity is 12%, the cost of debt is 6%, and the tax rate is 25%. The equity term is 0.60 × 12%, which is 7.2%. The after-tax cost of debt is 6% × (1 − 0.25), which is 4.5%, and the debt term is 0.40 × 4.5%, which is 1.8%. WACC is 7.2% + 1.8%, which is 9.0%.

Second example, with different weights: 70% equity at 10%, 30% debt at 5%, tax rate 20%. The equity term is 7.0%. The after-tax cost of debt is 4.0%, and the debt term is 1.2%. WACC is 8.2%. Notice how the tax shield works: the debt term uses 4.0%, not 5%, because a fifth of the interest is returned through lower tax. Notice also that the equity term dominates in both examples, because equity is both the larger weight and the higher cost — which is why the cost of equity is usually the input that matters most.

The cost of equity: CAPM and its problems

The cost of equity cannot be read off a contract, because shareholders have no promised return. The standard estimate is the capital asset pricing model, CAPM: the cost of equity equals the risk-free rate, plus beta times the market risk premium. The risk-free rate is the return on a government bond of matching maturity. Beta measures how much the company’s shares move with the market as a whole. The market risk premium is the extra return investors expect from shares over the risk-free rate.

Each input is an estimate with a range. Beta depends on the period and the market index used to estimate it, and it changes over time. The market risk premium depends on whether it is estimated from history or from current prices, and published estimates differ by several percentage points. The risk-free rate depends on which bond and which maturity is chosen. A cost of equity quoted to two decimal places is false precision: the honest statement is a range, and the WACC that follows from it is a range too.

Alternatives exist. The dividend discount model estimates the cost of equity from the share price, the dividend, and the expected dividend growth rate, but it only works for companies that pay steady dividends. The build-up method adds risk premiums for size, industry, and company-specific factors to the risk-free rate, and is common for private companies. None of them removes the estimation problem; they move it to different inputs.

The cost of debt and the tax shield

The cost of debt is easier: it is the rate the company actually pays, or would pay, to borrow. For a company with traded bonds, it is the yield to maturity on its debt of matching maturity. For bank borrowing, it is the interest rate on the facilities, including fees. For a new project, it is the marginal rate — what new borrowing would cost — not the average rate on old debt raised when rates were different.

The tax shield is real but limited. Interest is deductible, so each dollar of interest saves tax at the corporate rate, and the after-tax cost is the pre-tax rate times one minus the tax rate. But the shield is only worth something if the company pays tax: a company with losses, or in a jurisdiction with no corporate tax, gets little or no shield. And the shield assumes the debt level stays roughly constant; a company that plans to repay its debt will lose the shield as the debt falls.

Debt is not free money, even after tax. More debt raises the risk to shareholders, and shareholders demand a higher return for that risk — which raises the cost of equity and offsets part of the benefit of cheap debt. That trade-off is the heart of capital-structure theory, and it is why the WACC does not fall forever as debt rises: beyond a point, the rising cost of equity and the rising risk of distress push it back up.

Using WACC — and misusing it

The proper use is as a discount rate and a hurdle. In a discounted cash flow valuation, future cash flows are discounted at the WACC to give the value of the business. In a project decision, the project’s internal rate of return is compared with the WACC: above it, the project is expected to create value; below it, to destroy value. In both uses, the cash flows and the WACC must match: nominal with nominal, after-tax with after-tax, and the same capital structure assumed in both.

The misuse to avoid is applying a company WACC to a project of different risk. A safe, regulated utility project and a speculative new venture inside the same company do not have the same cost of capital, even though the company has one WACC. The correct hurdle for a project is the cost of capital for that project’s risk, estimated from comparable companies or adjusted for the risk difference. Using the company average for a risky project overstates its value; using it for a safe project understates it.

The second misuse is treating WACC as a fact rather than an estimate. Because the inputs are estimated, the WACC should be tested: change the cost of equity by a point, change the beta, change the weights, and see how the decision changes. If a project is only attractive at the most favourable end of every input’s range, it is not attractive — it is fragile. A decision that survives the plausible range of WACC is a decision worth making.

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