Corporate Finance
Cost of capital (WACC)
WACC is the blended after-tax cost of a company's equity and debt, and the discount rate for average-risk projects.
Definition
The weighted average cost of capital blends the cost of equity and the after-tax cost of debt in proportion to their market values. It is the minimum return a company must earn on its existing assets to satisfy both shareholders and lenders.
It is also the discount rate used in NPV and valuation for projects of average risk. A project riskier than the company needs a higher rate; a safer one needs a lower rate.
Intuition
Every source of capital has a price, and the company's capital is a weighted mix of those prices. Debt is cheaper because interest is tax-deductible.
When to use it
- Discounting a project whose risk matches the company's existing business.
- As an input to enterprise valuation and capital-structure decisions.
When not to use it
- Discounting a division or project with materially different risk without adjusting the rate.
- Using book weights when market values are available and differ substantially.
Formula
Weighted average cost of capital
WACC = (E ÷ V) × Re + (D ÷ V) × Rd × (1 − t)
Blends the cost of equity and the after-tax cost of debt.
- E
- Market value of equity
- D
- Market value of debt
- V
- E + D
- Re
- Cost of equity
- Rd
- Pre-tax cost of debt
- t
- Corporate tax rate
Formula
After-tax cost of debt
Rd × (1 − t)
Worked example
A simple WACC
Equity 600,000; debt 400,000; cost of equity 12%; cost of debt 7%; tax 25%.
- 1
Weights
V = 1,000,000, so E/V = 60% and D/V = 40%.
- 2
Equity term
0.60 × 12% = 7.2%.
- 3
Debt term
0.40 × 7% × (1 − 0.25) = 2.1%.
WACC = 9.3%. Projects of average risk must clear 9.3% to add value.
Measured by
These scoreboard metrics track or interpret this idea across the Lab.
Common mistakes
- Forgetting the (1 − t) shield on debt.
- Using the coupon on existing debt instead of the current market yield.
- Applying a company-wide WACC to a project of a different risk class.
How it connects
is used in
The source appears as an input to the target.
- NPV and IRR: WACC is the discount rate in NPV.
affects
Changing the source moves the target.
- Operating and financial leverage: Capital structure moves the weights inside WACC.
relates to
Useful to study together, in either order.
is an advanced form of
The source extends the target once the basics are secure.