Capital is not free
A company raises money from two broad sources: shareholders, who expect a return for the risk they carry, and lenders, who charge interest. The weighted average cost of capital (WACC) blends those two costs into a single rate.
WACC is the minimum return a company must earn on its existing assets to satisfy everyone who funded them. It is also the discount rate used in valuation and the hurdle rate used to accept or reject projects of average risk.
The logic is opportunity cost. If a project cannot beat what investors could earn elsewhere at similar risk, it destroys value even when its accounting profit looks positive.
Key points
- Equity is more expensive than debt because shareholders are paid last.
- Interest is tax-deductible, so debt's effective cost is lower than its interest rate.
- WACC is a blended, after-tax, market-value-weighted rate.
Building the rate piece by piece
Re = Rf + β × (Rm − Rf)
The return shareholders require, built from the risk-free rate plus a premium for market risk.
- Rf
- Risk-free rate
- β
- Sensitivity of the shares to the market
- Rm
- Expected market return
Rd (after tax) = Rd × (1 − t)
The interest rate reduced by the tax shield on interest.
E/V and D/V, where V = E + D
Market values, not book values, drive the weights.
WACC = (E/V) × Re + (D/V) × Rd × (1 − t)
The blended after-tax cost of all capital.
The market risk premium is Rm − Rf. Beta scales that premium up or down for the specific shares: a beta above one means the shares amplify market moves.
Nova Manufacturing's cost of capital
Nova has a market value of equity of ৳6,200,000 and debt of ৳3,300,000, so total capital is ৳9,500,000. Equity is 65.26% of capital and debt is 34.74%.
With a risk-free rate of 6%, a beta of 1.15, and an expected market return of 12%, the cost of equity is 6% + 1.15 × (12% − 6%) = 12.9%. The pre-tax cost of debt is 9.5%; at a 25% tax rate its after-tax cost is 9.5% × 0.75 = 7.125%.
WACC = 0.6526 × 12.9% + 0.3474 × 7.125% = 10.89%. Any average-risk project must clear 10.89% to add value.
Key points
- Cost of equity: 12.9%. After-tax cost of debt: 7.125%.
- WACC: 10.89%.
- Debt is cheaper even before tax, and the tax shield widens the gap.
Using WACC well
WACC is only correct for projects of average risk. A riskier division or a start-up venture needs a higher rate; a safer, contracted project can use a lower one. Applying the group WACC to everything quietly overvalues risky projects and undervalues safe ones.
Use marginal WACC, not historical. The question is what the next taka of capital costs today, at today's market values and rates, not what the last raise cost.
More debt lowers WACC at first because debt is cheap and tax-advantaged. Beyond a point, lenders demand a higher rate and shareholders demand more for financial risk, so WACC turns upward. The minimum is a range, not a precise point.
Key points
- Match the discount rate to the project's risk, not the company's average.
- Use market values and current rates for the weights.
- There is a debt level beyond which WACC rises again.
Interactive experiment
Cost of capital and CAPM
WACC is the blended after-tax cost of the capital a company uses. It becomes the discount rate for projects of average risk.
WACC = (E/V) × Re + (D/V) × Rd × (1 − t)
Your inputs
E in the formula.
D in the formula.
Return on a default-free asset.
Sensitivity of the shares to the market.
Return expected from the market portfolio.
Interest rate on borrowings.
Effective corporate tax rate.
Result
- WACC
- 10.9%
- Cost of equity (CAPM)
- 12.9%
- After-tax cost of debt
- 7.1%
- Equity weight
- 65.3%
- Debt weight
- 34.7%
- Market risk premium
- 6.0%
- Total capital
- ৳9,500,000
WACC is 10.89%, below the 12.90% cost of equity because cheaper, tax-advantaged debt is in the mix. Use WACC only for average-risk projects.
03 / Apply
Should Solstice Power build the solar plant?
Solstice Power is financed 60% by equity and 40% by debt. Its cost of equity is 12.2% and its pre-tax cost of debt is 8% at a 25% tax rate. The board is reviewing a solar project expected to return 11%.
The assumptions
- The project carries the same risk as the company's existing assets.
- Capital weights stay at 60% equity and 40% debt.
- The 11% return is stated after tax, so it is comparable with WACC.
What to take away
01
After-tax cost of debt is 8% × 0.75 = 6%.
02
WACC is 0.60 × 12.2% + 0.40 × 6% = 9.72%.
03
An 11% return clears the hurdle, so the project adds value on these assumptions.
Your turn
0 of 4 answered
01Question
The risk-free rate is 5%, beta is 1.2, and the expected market return is 11%. What is the cost of equity?
02Question
Pre-tax cost of debt is 8% and the tax rate is 25%. What is the after-tax cost of debt?
03Question
With 60% equity at a cost of 12.2% and 40% debt at an after-tax cost of 6%, what is WACC?
04Question
A division is clearly riskier than the group average. Which discount rate should its project use?
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OpenStax · Principles of Finance, Chapter on Cost of Capital ↗Educational sample content. Worked examples use hypothetical figures. Dates refer to the note's latest content update.