WACC explained: what it is and how to calculate it

The weighted average cost of capital is the return a company must earn on its operations to satisfy everyone who finances it. In a DCF it is the rate used to discount unlevered free cash flows.

The formula

WACC = E/(D+E) × cost of equity + D/(D+E) × cost of debt × (1 − tax rate)

E and D are market values of equity and debt. Debt is multiplied by (1 − tax rate) because interest is tax-deductible.

Cost of equity

Usually from the capital asset pricing model:

Cost of equity = risk-free rate + beta × equity risk premium

• Risk-free rate: the yield on a long-dated government bond in the cash flows' currency.
• Beta: how much the share moves with the market. Take the betas of comparable companies, unlever each, average, then relever at the target's capital structure.
• Equity risk premium: the extra return investors require for shares over government bonds, commonly taken at around 5 to 6%.

Cost of debt

The yield the company would pay on new long-term debt today, not the coupon on old bonds.

Worked example

Equity is 60% of capital and costs 10%. Debt is 40% and costs 5% before tax. The tax rate is 20%.

WACC = 0.6 × 10% + 0.4 × 5% × 0.8 = 6.0% + 1.6% = 7.6%

How it moves

• More debt lowers WACC at first, because debt is cheaper and tax-deductible. Beyond a point, rising risk pushes up the cost of both debt and equity and WACC rises again.
• Higher interest rates raise both components.
• A riskier business has a higher beta and a higher WACC.

Questions to expect

• Why is equity more expensive than debt? Shareholders are paid last and have no fixed claim, so they require more.
• Which has the higher WACC, a utility or a software start-up? The start-up: higher beta and little debt.
• What discount rate goes with levered cash flows? The cost of equity, not WACC.
• How do you find beta for a private company? From listed comparables, unlevered and relevered.

See the full walkthrough in walk me through a DCF.