Weighted average cost of capital, often called WACC, is the average rate of return a company must earn to satisfy the investors who provide its capital.
A company’s capital usually comes from a mix of debt and equity. Debt investors expect interest payments, while equity investors expect returns through stock price appreciation, dividends, or business value growth. WACC combines those required returns into one blended rate.
In fundamental investing, WACC is commonly used as a discount rate in a discounted cash flow (DCF) model.
Why Weighted Average Cost of Capital (WACC) Matters
Weighted average cost of capital matters because it helps investors estimate whether a company is creating or destroying value.
A business creates value when it earns a return on invested capital above its cost of capital.
Return on Invested Capital (ROIC) > WACC = Potential value creation
Return on Invested Capital (ROIC) < WACC = Potential value destructionFor example, if a company earns a 15% return on invested capital (ROIC) and its WACC is 9%, the business may be creating value. If another company earns a 6% ROIC with the same 9% WACC, that business may be destroying value even if it is growing.
Fundamental investors use WACC to answer:
“What minimum return does this company need to earn to justify the capital invested in the business?”
Weighted Average Cost of Capital (WACC) Formula
A common WACC formula is:
WACC = (E ÷ V × Re) + (D ÷ V × Rd × (1 - Tax Rate))Where:
E = Market value of equity
D = Market value of debt
V = Total value of capital, or E + D
Re = Cost of equity
Rd = Cost of debt
Tax Rate = Corporate tax rateThe debt portion is adjusted for taxes because interest expense is generally tax-deductible.
Main Components of Weighted Average Cost of Capital (WACC)
| Component | What It Means |
|---|---|
| Market Value of Equity | The market value of the company’s common stock. |
| Market Value of Debt | The market value of the company’s interest-bearing debt. |
| Cost of Equity | The return shareholders require for owning the stock. |
| Cost of Debt | The interest rate lenders require for lending to the company. |
| Tax Rate | Used to calculate the after-tax cost of debt. |
| Capital Structure | The mix of debt and equity used to finance the business. |
Example of Weighted Average Cost of Capital (WACC)
Suppose a company has the following capital structure:
Market value of equity: $800 million
Market value of debt: $200 million
Total capital: $1 billion
Cost of equity: 10%
Cost of debt: 5%
Tax rate: 25%First, calculate the weight of equity and debt:
Equity weight = $800 million ÷ $1 billion = 80%
Debt weight = $200 million ÷ $1 billion = 20%Then calculate the after-tax cost of debt:
After-tax cost of debt = 5% × (1 - 25%)
After-tax cost of debt = 3.75%Now calculate WACC:
WACC = (80% × 10%) + (20% × 3.75%)
WACC = 8.00% + 0.75%
WACC = 8.75%In this example, the company’s weighted average cost of capital is 8.75%.
That means the company must earn more than 8.75% on its invested capital to create value.
Weighted Average Cost of Capital (WACC) in a DCF Model
In a discounted cash flow (DCF) model, WACC is often used as the discount rate when valuing the entire business, also called enterprise value.
A DCF model estimates future free cash flow and discounts those cash flows back to today.
Present Value = Future Cash Flow ÷ (1 + WACC) ^ Number of YearsThe higher the WACC, the lower the present value of future cash flows.
The lower the WACC, the higher the present value of future cash flows.
This matters because small changes in WACC can create large changes in estimated intrinsic value.
WACC and Enterprise Value
WACC is usually used when valuing enterprise value, not just equity value.
Enterprise value represents the value of the whole operating business before subtracting debt and adding cash.
A simplified valuation flow looks like this:
Present Value of Future Free Cash Flow
+ Present Value of Terminal Value
= Enterprise Value
Enterprise Value
- Net Debt
= Equity Value
Equity Value
÷ Shares Outstanding
= Intrinsic Value Per ShareBecause WACC reflects both debt and equity capital, it is most appropriate when discounting free cash flow to the firm.
Cost of Equity vs. Cost of Debt
Cost of equity is the return shareholders require for taking the risk of owning the stock.
Cost of debt is the return lenders require for lending money to the company.
Debt is usually cheaper than equity because lenders have a higher claim on the company’s assets and receive contractual interest payments. Equity is usually more expensive because shareholders take more risk and are paid after lenders.
However, too much debt can increase financial risk and raise the company’s overall cost of capital.
WACC vs. Discount Rate
WACC is one type of discount rate.
A discount rate is any required rate of return used to convert future cash flows into present value.
In simple terms:
Discount Rate = General required return used in valuation
WACC = Blended cost of debt and equity used as a discount rate for the whole businessWACC is often used in business valuation and DCF models. Other discount rates may be used for equity-only cash flows, private investments, bonds, or projects with different risk levels.
WACC vs. Return on Invested Capital (ROIC)
Return on invested capital (ROIC) measures how efficiently a company generates profit from the capital invested in the business.
Weighted average cost of capital (WACC) measures the company’s blended required return from debt and equity investors.
The comparison is important:
ROIC - WACC = Economic spreadA positive spread may suggest value creation. A negative spread may suggest value destruction.
Example:
ROIC: 14%
WACC: 9%
Economic Spread: 5%A company with a positive and durable economic spread may have strong business quality, pricing power, or an economic moat.
What Is a Good WACC?
A “good” WACC depends on the company, industry, capital structure, interest rates, and business risk.
A lower WACC may indicate that investors view the business as less risky or more reliable. A higher WACC may indicate higher perceived risk, more expensive capital, or weaker financial stability.
As a general guide:
| WACC Level | Possible Interpretation |
|---|---|
| Lower WACC | May indicate lower risk, stable cash flows, or cheaper access to capital. |
| Higher WACC | May indicate higher risk, unstable cash flows, or expensive capital. |
| Rising WACC | May reduce intrinsic value and make new investments harder to justify. |
| Falling WACC | May increase intrinsic value and improve investment economics. |
A low WACC is not automatically good if the company invests poorly. A high WACC is not automatically bad if the company can still earn strong returns above it.
Factors That Affect Weighted Average Cost of Capital (WACC)
WACC may be affected by:
- Interest rates
- Credit risk
- Debt levels
- Business stability
- Stock volatility
- Capital structure
- Tax rate
- Industry risk
- Inflation expectations
- Investor required returns
- Company size
- Profitability
- Balance sheet strength
- Market conditions
When interest rates rise, WACC often rises. When WACC rises, the present value of future cash flows usually falls.
Limitations of Weighted Average Cost of Capital (WACC)
WACC is useful, but it has limitations.
Common limitations include:
- It depends on estimates for cost of equity.
- It can change as interest rates and market prices change.
- It may not reflect different risk levels across business segments.
- It may be misleading for highly leveraged companies.
- It may not work well for distressed businesses.
- It may be less useful for early-stage companies with unstable cash flows.
- Small changes in WACC can significantly change valuation results.
Investors should treat WACC as an estimate, not an exact number.
Common WACC Mistakes
Common mistakes include:
- Using book value instead of market value for capital weights
- Using pre-tax cost of debt instead of after-tax cost of debt
- Applying one company-wide WACC to every project
- Using an unrealistic cost of equity
- Ignoring changes in interest rates
- Assuming capital structure will remain constant forever
- Using WACC for equity cash flows instead of firm cash flows
A WACC estimate should be reasonable, consistent, and matched to the type of cash flow being valued.
Weighted Average Cost of Capital (WACC) in Fundamental Investing
In fundamental investing, WACC helps connect business quality, risk, and valuation.
A company with a durable competitive advantage may be able to earn returns above WACC for many years. That can increase intrinsic value.
A company with weak competitive advantages may earn returns near or below WACC. That can limit value creation even if revenue grows.
Investors often use WACC alongside:
- Return on invested capital (ROIC)
- Free cash flow
- Discounted cash flow (DCF)
- DCF Model
- Intrinsic Value
- Enterprise Value
- Debt-to-Equity Ratio
- Interest Coverage Ratio
- Economic Moat
- Capital Allocation
Related Terms
- Discount Rate
- Discounted Cash Flow (DCF)
- DCF Model
- Return on Invested Capital (ROIC)
- Cost of Equity
- Cost of Debt
- Capital Structure
- Enterprise Value
- Net Debt
- Free Cash Flow
- Intrinsic Value
- Terminal Value
- Economic Moat
- Capital Allocation
- Fundamental Analysis
- Value Investing