Weighted Average Cost of Capital

A company is funded by two kinds of people: lenders, who want a fixed return and get paid first, and shareholders, who want a higher return and get paid last, if at all. Before a project or a whole business is worth anything, it has to clear both hurdles at once. WACC is that combined hurdle rate — the minimum return the firm's assets must generate to keep both sides satisfied.

It is a weighted average of two costs, weighted by how much of the company's financing comes from each source:

$$\text{WACC} = \frac{E}{E+D}\, r_e \;+\; \frac{D}{E+D}\, r_d (1 - t)$$

In words: take the cost of equity, $r_e$, and multiply it by equity's share of total capital; take the cost of debt, $r_d$, multiply it by debt's share, and shrink it by $(1-t)$ because interest is tax-deductible; add the two pieces together. $E$ and $D$ are market values, not book values — what the equity and debt would actually trade for today, since that is what determines how expensive that dollar of financing really is.

A worked example

A company has $800m of equity at market value and $200m of debt, so total capital is $1,000m: 80% equity, 20% debt. Its cost of equity, from CAPM, is 11%. Its debt trades to yield 5%, and the tax rate is 25%, so the after-tax cost of debt is $5\% \times (1 - 0.25) = 3.75\%$.

$$\text{WACC} = 0.80 \times 11\% + 0.20 \times 3.75\% = 8.8\% + 0.75\% = 9.55\%$$

Any project or acquisition this company evaluates needs to clear roughly 9.55% before financing costs to be worth doing — anything less destroys value even if it looks "profitable" in isolation.

Now suppose the company borrows more, shifting the mix to 60% equity, 40% debt, and — because more debt makes equity riskier — cost of equity rises to 12.5% while cost of debt stays 5%. WACC becomes $0.60 \times 12.5\% + 0.40 \times 3.75\% = 7.5\% + 1.5\% = 9.0\%$. The discount rate fell even though borrowing got no cheaper, because debt is a cheaper source of capital than equity up to a point — the mechanism behind Modigliani-Miller and its real-world exceptions.

WACC shows up everywhere a whole business, not just its equity, is being valued: discounted cash flow models, capital budgeting decisions, and comparing a company's return on invested capital against the rate it costs to raise that capital in the first place.