Weighted average cost of capital
What is Weighted average cost of capital?
Weighted average cost of capital is the market-value-weighted required return on a company's operating capital from debt, equity, and other financing sources. It is normally used to discount cash flows available to all capital providers.
How WACC is constructed
A standard formula weights cost of equity and after-tax cost of debt by their market values, adding preferred or other capital when material. Cost of equity may use a factor model, while debt cost reflects current borrowing conditions and default risk. Tax benefit applies only where interest deductions are expected and economically usable.
Why WACC is used
WACC is commonly used to discount FCFF and evaluate investments with risk similar to the operating business. It represents the return required collectively by capital providers, not the coupon on debt or the accounting cost of financing. A project with different risk, geography, currency, or leverage may require a different rate.
Example
A company financed 75% by market-value equity and 25% by debt has 9% cost of equity and 5% pretax debt cost. With a 25% marginal tax rate and usable deductions, simplified WACC is about 7.69%. Changing target leverage or business risk changes the rate and potentially the value.
How to interpret it
Use target or sustainable market-value capital structure, not stale accounting weights. Match currency and nominal or real basis to cash flows. Review risk-free rate, equity premium, beta, debt spread, tax, and country exposure. For a multi-business company, segment-specific costs can be more informative than one corporate WACC.
Limitations
Every component is estimated and can create false precision. Circularity arises because market values depend partly on valuation. Debt beta, tax shields, leases, pensions, and changing leverage complicate simple formulas. WACC is unsuitable for equity cash flows and can misvalue projects whose risk differs materially from the existing company.
Practical checklist
Document every input, date, source, currency, tax assumption, and capital weight. Reconcile debt and equity claims, test alternative betas and premiums, and use current marginal financing cost rather than historical coupon alone. Match WACC with FCFF, adjust through forecast stages when risk changes, and publish valuation sensitivity instead of one unsupported decimal.
Also known as: WACC, cost of capital
Sources and further reading
- An Introduction to Valuation, Aswath Damodaran, NYU Stern