What it calculates

Weighted average cost of capital is the blended return a company must earn to satisfy everyone who funded it - shareholders and lenders together. It is the discount rate you apply to unlevered free cash flow in a DCF, and the hurdle rate a project has to clear before it creates value rather than destroys it.

How it is calculated

WACC weights the cost of each capital source by its share of total capital. Cost of equity comes from CAPM: the risk-free rate plus beta times the equity risk premium. Cost of debt is the pre-tax rate reduced by the tax shield, because interest is deductible. The two are then combined as (E/V x cost of equity) + (D/V x after-tax cost of debt), where V is equity plus debt.

How to read the result

A lower WACC means capital is cheaper and more projects clear the bar. Compare the number against your return on invested capital: if ROIC sits below WACC, the business is destroying value no matter how fast revenue grows. Small changes matter more than they look - a single point of WACC can move a DCF valuation by double digits, because it compounds across every year of the forecast.

Worked example

Take equity of 700 and debt of 300, so V is 1,000 and the weights are 70% and 30%. With a risk-free rate of 4%, beta of 1.2 and an equity risk premium of 5.5%, cost of equity is 4% + 1.2 x 5.5% = 10.6%. Pre-tax cost of debt of 6% at a 25% tax rate gives an after-tax cost of 4.5%. WACC is 0.7 x 10.6% + 0.3 x 4.5% = 8.77%.

Common questions

Should I use book values or market values for the weights?

Market values. Book equity reflects historical accounting, not what shareholders would accept today. For debt, book value is usually a reasonable proxy unless the debt trades far from par or was issued at a very different rate environment.

Why is the cost of debt reduced by the tax rate but not the cost of equity?

Interest is tax-deductible, so every dollar of interest reduces taxable income and the government effectively pays part of it. Dividends and retained earnings are paid out of after-tax profit, so there is no equivalent shield on equity.

What if the company has no debt?

Then WACC equals the cost of equity, because the debt weight is zero. That is common for early-stage companies, and it is why an unlevered business often shows a higher discount rate than a comparable leveraged one.