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.
WACC explained simply
WACC is the average return a company must pay everyone who funds it, weighted by how much each source provides, with debt counted after tax: WACC = (E/V) × cost of equity + (D/V) × cost of debt × (1 − tax rate). With 60% equity at 10% and 40% debt at 6% before a 25% tax rate, WACC is 7.8%.
What this WACC lesson covers
- 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
WACC formula, explained
- 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
How to calculate WACC step by step (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%
Cost of equity vs cost of debt in WACC
| Cost of equity | Cost of debt | |
|---|---|---|
| Who is paid | Shareholders | Lenders and bondholders |
| How it's found | Usually CAPM | Interest rate or bond yield |
| Tax adjustment | None | × (1 − tax rate), because interest is usually deductible |
| Usually | Higher (paid last, more risk) | Lower (paid first, less risk) |
Is being debt-free the responsible choice? David's take
I consider myself a responsible finance guy, and for decades I believed being debt-free was simply the responsible choice. Look at WACC and you see why that's odd. In the example, debt costs 4.5% after tax while equity costs 10%. Remove all debt and the company's cost of capital rises from 7.8% to 10%. Avoiding debt completely is like owning a car and never driving it, or refusing to cook with fire because fire can be deadly. Debt can kill a company if it's out of control. The answer is control, not zero.
From David's concept: Reconsidering the Debt-Free Convention. This is David's opinion, alongside the standard textbook answer above.
Harder WACC questions
Is the tax shield worth anything if the company is losing money?
Not this year. With no taxable profit, interest saves no tax now, so use the pre-tax cost of debt (unless losses can be carried forward and used soon). In the lesson's example, WACC rises from 7.8% to 8.4% (60% × 10% + 40% × 6%).
How do you calculate WACC for a startup with no debt and no share price?
With no debt, WACC equals the cost of equity. Estimate it from similar listed companies' betas (unlevered for your structure), then add judgement for size, illiquidity and the chance of failure. Early-stage investors usually demand far more than a CAPM figure, so treat a CAPM-only startup WACC as a floor.
Does adding more debt always lower WACC?
No. At first, cheaper after-tax debt pulls WACC down. But more debt makes equity riskier, so its cost rises (Modigliani–Miller Proposition II), and past some point the risk of financial distress pushes the total back up. That's why companies look for a target mix, not maximum debt.
Common WACC 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.