What Is Weighted Average Cost of Capital?

The weighted average cost of capital (WACC) represents the average rate a company pays to finance its assets. It blends the cost of equity and cost of debt, weighted by their respective shares in the firm’s capital structure. Because businesses typically fund growth through a mix of stock issuance and borrowing, WACC provides a single number summarizing the overall opportunity cost of raising money. Financial professionals rely on WACC to evaluate mergers, new projects, and the minimum return investors expect in exchange for risk.

The WACC Formula

The standard equation expresses WACC as:

Here, $E$ is the market value of equity, $D$ is the market value of debt, and $V$ equals $E+D$. The variables $\mathrm{R\_e}$ and $\mathrm{R\_d}$ represent the cost of equity and cost of debt. Finally, $\mathrm{T\_c}$ is the corporate tax rate. Because interest payments are tax-deductible, the cost of debt is adjusted by $1-\mathrm{T\_c}$ to account for the tax shield.

Gathering the Inputs

Estimating WACC requires several figures. The equity and debt values come from the company’s balance sheet or market capitalization. Cost of equity often relies on the Capital Asset Pricing Model (CAPM), which uses the risk-free rate, beta, and market risk premium. Cost of debt can be estimated from the yield on outstanding bonds or the interest rate on loans. Finally, the corporate tax rate depends on jurisdiction; large U.S. corporations currently pay around 21% federal tax.

Step-by-Step Example

Imagine a company with $60 million in market equity and $40 million in debt. The cost of equity is 9%, the cost of debt is 5%, and the tax rate is 21%. The total value $V$ is $100 million. Applying the formula:

This gives a WACC of roughly 6.78%. Managers would use this as the minimum return rate when discounting future cash flows or comparing investment opportunities.

Why WACC Matters

Because WACC reflects the blended cost of financing, it serves as a hurdle rate for new projects. If a potential expansion offers returns above the WACC, it adds value to the company. If it falls below, shareholders might prefer the company to return excess cash or seek cheaper funding. WACC also influences valuation models like discounted cash flow (DCF). A higher WACC reduces the present value of future earnings, leading to a lower valuation. Conversely, a lower WACC indicates a cheaper cost of capital and potentially higher firm value.

Components of Capital Structure

Component	Description
Equity	Common and preferred stock issued by the company
Debt	Bonds, loans, and other interest-bearing obligations
Tax Rate	Effective rate on corporate income

Practical Considerations

WACC assumes the capital structure remains constant over time. In reality, companies may raise or repay debt, issue new shares, or buy back stock. Analysts update WACC periodically to reflect these changes. Additionally, the cost of equity is difficult to observe directly, so models like CAPM or dividend discount may yield different results. Sensitivity analysis helps gauge how varying assumptions affect the final number.

Limitations

WACC is only as accurate as the inputs. Market conditions, interest rates, and tax policies can change rapidly. Private companies without traded stock may have to estimate equity value from comparable firms. Also, WACC represents a blended average; specific projects may carry higher or lower risk than the company as a whole. Despite these caveats, WACC remains a core metric in corporate finance because it encapsulates a firm’s overall financing cost in a single figure.

Conclusion

By combining the costs of debt and equity, weighted by their proportions, WACC helps investors and managers assess opportunities on equal footing. Use this calculator to estimate your own company’s cost of capital, experiment with different capital structures, and inform strategic planning.