Glossary term
Weighted Average Cost of Capital (WACC)
Weighted average cost of capital is a company's blended after-tax cost of financing from debt, equity, and other capital sources, weighted by their share of the capital structure.
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What Is Weighted Average Cost of Capital?
Weighted average cost of capital, or WACC, is a company's blended cost of financing from debt, equity, and sometimes preferred stock, weighted by each source's share of the company's capital structure. It is commonly used as a discount rate in valuation and as a hurdle rate for capital budgeting.
WACC is not an accounting expense shown directly on the income statement. It is an estimate of what capital providers require, after considering the cost of debt, the cost of equity, the tax effect of interest, and the company's financing mix.
Key Takeaways
- WACC estimates a company's average after-tax cost of capital.
- It blends the cost of equity and after-tax cost of debt using capital-structure weights.
- Analysts use WACC to discount free cash flow to the firm and evaluate investment projects.
- A project should generally earn more than its appropriate cost of capital to create value.
- Small changes in WACC assumptions can materially change valuation estimates.
Formula
A common simplified WACC formula is:
Here, E is the market value of equity, D is the market value of debt, V is total capital value, Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. Preferred stock can be added as another weighted component when it is material.
For example, if a company is financed 70% with equity costing 10% and 30% with debt costing 5% before tax, and its tax rate is 25%, its WACC is 8.125%: 70% x 10% plus 30% x 5% x 75%.
How Analysts Use WACC
WACC is often used to discount free cash flow to the firm because those cash flows are available to all capital providers before interest payments. In capital budgeting, management may compare a project's expected return with a project-specific cost of capital. If the return is below the relevant hurdle rate, the project may destroy value even if it is profitable in accounting terms.
WACC also helps explain valuation sensitivity. A lower discount rate raises the present value of future cash flows, while a higher discount rate lowers it. That is why growth companies and long-duration assets can be especially sensitive to cost-of-capital assumptions.
Where the Estimate Can Mislead
WACC should match the risk of the cash flows being valued. A company-wide WACC may be inappropriate for a project that is much riskier or safer than the existing business. It can also be misleading when capital structure is unstable, debt is distressed, tax shields are uncertain, or market values are hard to estimate.
The cost of equity is usually the hardest input. Different models, beta estimates, market risk premiums, and country-risk assumptions can produce different answers. Good valuation work usually tests a range of WACC assumptions rather than pretending one estimate is precise.
Assumption Discipline
Small WACC changes can have large valuation effects, especially for businesses whose cash flows are expected far in the future. A lower WACC can make a long-duration growth story look much more valuable, while a higher WACC can compress that valuation quickly.
Analysts usually test WACC across a range rather than relying on one point estimate. Market-value weights, target capital structure, tax rate, debt cost, equity risk premium, beta, and country risk all deserve explicit attention before the number is used as a discount rate.
The Bottom Line
WACC is the blended cost of the capital a company uses to finance its assets. It is central to valuation and capital budgeting, but it is only as useful as the assumptions behind its debt cost, equity cost, tax rate, capital structure, and risk match.