FINANCE · COST OF CAPITAL
WACC: Weighted Average Cost of Capital, Formula, and Example
Weighted average cost of capital, or WACC, estimates the return required by a business’s providers of debt and equity capital, weighted by their shares of total capital. It helps connect financing assumptions to investment decisions. WACC is an estimate of a required return, not a guaranteed return or a simple average of interest rates.
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The WACC formula
For a business financed with ordinary equity and interest-bearing debt:
WACC = [E ÷ (D + E)] × Re + [D ÷ (D + E)] × Rd × (1 − T)
| Symbol | Meaning | Practical question |
|---|---|---|
| E | Market value of equity | What is the equity currently worth? |
| D | Market value of interest-bearing debt | What is the debt currently worth? |
| Re | Required return on equity | What return compensates shareholders for risk? |
| Rd | Current pretax cost of debt | What rate would lenders currently require? |
| T | Applicable marginal tax rate for the interest tax shield | Can the business actually use the assumed deduction? |
If preferred stock or other material sources of capital exist, include their weights and appropriate costs. All financing weights must total 100%. Trade payables normally belong in operating working capital rather than the interest-bearing financing debt used in this simplified formula.
Worked example: a 9.3% WACC
Assume a hypothetical business has equity worth $600,000 and debt worth $400,000. Its estimated cost of equity is 12%, its current pretax debt cost is 7%, and its applicable tax rate is 25%. Assume interest is fully deductible and the tax benefit is usable. These are teaching assumptions, not current market benchmarks.
| Capital source | Value | Weight | Relevant cost | Weighted contribution |
|---|---|---|---|---|
| Equity | $600,000 | 60% | 12.00% | 7.20 percentage points |
| Debt | $400,000 | 40% | 7% × (1 − 25%) = 5.25% | 2.10 percentage points |
| Total | $1,000,000 | 100% | — | 9.30% |
WACC = 0.60 × 0.12 + 0.40 × 0.07 × 0.75 = 0.093 = 9.3%
The debt tax adjustment is applied once. If someone supplies an already-after-tax debt cost of 5.25%, multiplying that rate by (1 − T) again understates WACC.
Where the inputs come from
Equity weights
For a listed company, share price times relevant shares outstanding provides a starting point for equity market value. Accounting equity is a different measure. For a private company, equity value and an appropriate target financing mix require estimation; historical owner contributions alone do not establish current market value.
Debt cost
Use a current borrowing cost consistent with currency, maturity, and credit risk. A bond’s current yield to maturity may be informative; an old coupon rate may not describe today’s required return. Book debt may approximate market debt in some situations, but assess that assumption rather than using book values automatically.
Equity cost
One common estimate is the capital asset pricing model: Re = risk-free rate + beta × equity market risk premium. For example, a 4% risk-free rate, beta of 1.2, and a 6% market risk premium imply 11.2%. The inputs are hypothetical. A market risk premium is not the same as the total expected market return. Private-company estimates often require comparable-company analysis and careful adjustments.
Tax effect
The simple (1 − T) adjustment assumes the interest tax shield can be used. Losses, deduction limits, and differences in tax treatment can change its value. Do not assume every dollar of interest produces an immediate tax saving.
Use WACC with the right cash flows
WACC is commonly paired with after-tax cash flows available to both debt and equity investors, before debt interest and principal payments. In a project NPV model, deducting financing interest in those cash flows and also using WACC can count financing costs twice.
Cash flows available only to shareholders call for an equity-consistent discount rate. Keep currency, inflation treatment, timing, and risk aligned. Use a nominal rate with nominal cash flows and a real rate with real cash flows. Material shifts in leverage or project risk may require another approach.
Apply this logic in the NPV guide. Compare an appropriate project IRR with a risk-consistent required return, while checking IRR’s limitations.
Test the estimate instead of hiding uncertainty
| Case | Cost of equity | Pretax debt cost | WACC |
|---|---|---|---|
| Lower required returns | 10% | 6% | 7.8% |
| Base case | 12% | 7% | 9.3% |
| Higher required returns | 14% | 8% | 10.8% |
Explore each financing input
Use the Cost of Debt guide for pretax rates and usable interest tax benefits, and Cost of Equity for CAPM inputs. Then examine how the discount rate affects Terminal Value.
All three cases retain 60% equity, 40% debt, and a usable 25% debt tax shield. Recalculate project NPV across a defensible range. A project that barely passes at one estimated rate deserves closer review of both the rate and the cash-flow assumptions.
Common mistakes
- Calling owner funding free. Equity has an opportunity cost even without a contractual interest payment.
- Using the loan rate as the hurdle rate. Debt is only one source of capital.
- Mixing book and market weights without explanation. State the basis and justify approximations.
- Increasing debt and assuming WACC must fall. More leverage can increase lender and shareholder risk.
- Using one WACC for unrelated projects. Different operating risks may need different required returns.
- Treating precision as certainty. A rate calculated to two decimal places still depends on estimates.
Frequently asked questions
Is WACC the same as a hurdle rate?
Not always. A hurdle rate is a decision threshold. Management may start with a suitable cost of capital and incorporate other constraints, but any adjustment should have a clear rationale.
Does positive NPV mean financing is available?
No. Economic value, lender approval, debt covenants, and liquidity are separate questions. Use a three-statement forecast to examine profit, debt balances, and cash needs.
Sources and learning notes
Further reading: OpenStax, Calculating WACC, and ACCA, International Project Appraisal. The examples and input ranges are original educational illustrations. Actual financing and tax assumptions require business-specific analysis.