Institute of Equity.

Weighted Average Cost of Capital (WACC)

Deconstructing the discount rate: the math behind CAPM, the tax shield on debt, and how capital structure dictates hurdle rates.

The Concept of WACC

The Weighted Average Cost of Capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. It represents the minimum acceptable return a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital.

In a DCF model, WACC is the discount rate used to calculate the present value of future free cash flows.

The WACC Formula

WACC = [ % Equity × Cost of Equity ] + [ % Debt × Cost of Debt × (1 - Tax Rate) ]

Note: If the company issues preferred stock, a third term (% Preferred × Cost of Preferred) is added.

Cost of Equity (Ke)

Unlike debt, which has a stated interest rate, equity does not have an explicit cost. Therefore, the Cost of Equity is theoretical and typically calculated using the Capital Asset Pricing Model (CAPM).

Cost of Equity = Risk-Free Rate + Beta × (Equity Risk Premium)
  • Risk-Free Rate: The yield on a 10-year US Treasury bond. It represents the return an investor expects for zero risk.
  • Beta: A measure of a stock's volatility relative to the overall market (usually the S&P 500). A beta of 1.0 means the stock moves exactly with the market.
  • Equity Risk Premium (ERP): The extra return investors expect for taking on the risk of investing in equities rather than risk-free bonds (historically ~5-6%).

Cost of Debt (Kd)

The Cost of Debt is more straightforward. It is the effective yield a company pays on its current debt.

Crucially, because interest expense is tax-deductible in most jurisdictions, the true cost to the company is lower than the nominal interest rate. This is why the formula includes (1 - Tax Rate).

After-Tax Cost of Debt = Interest Rate × (1 - Corporate Tax Rate)

The Weights (% Equity and % Debt)

The weights in the WACC formula should ideally reflect the company's target capital structure based on market values, not book values. If a company's market capitalization (equity value) is $800M and its market value of debt is $200M, the weights are 80% equity and 20% debt.