What Is WACC? The Formula, Cost of Equity and Debt, and What It's Used For

That's how CFI (the Corporate Finance Institute) defines it. CFI also describes WACC as the discount rate used when valuing a business or a project with the unlevered free cash flow approach, and as the required rate an investor needs before they'll consider investing in the business. In plain terms, it's what your capital costs you on average, once you've accounted for where each part of it came from.

The WACC formula, letter by letter

CFI writes the formula as WACC = (E/V x Re) + ((D/V x Rd) x (1 - T)). Every letter is one input:

Symbol	What it means (CFI)
E	Market value of the firm's equity (its market cap)
D	Market value of the firm's debt
V	Total value of capital, equity plus debt
E/V and D/V	The percentage of capital that's equity and the percentage that's debt
Re	Cost of equity, the required rate of return
Rd	Cost of debt, the yield to maturity on existing debt
T	Tax rate

An extended version adds a third term for preferred stock, for companies that have it. CFI explains that the point of WACC is to cost each part of the capital structure in proportion to how much equity, debt and preferred stock the business has. A company usually pays a fixed rate of interest on its debt and a fixed dividend on preferred stock. It doesn't pay a fixed return on common equity, though it often pays cash dividends.

Where each WACC input comes from

Input	Meaning (CFI)	Where it comes from
E/V, D/V	Equity and debt shares of total capital	Market values of equity and debt
Re	Cost of equity = Rf + beta x (Rm - Rf)	The Capital Asset Pricing Model (CAPM)
Rd x (1 - T)	After-tax cost of debt	Yield to maturity on debt and the tax rate
Preferred stock	Dividend yield, no tax shield	Dividends paid after tax

Cost of equity: the CAPM part

CFI calculates the cost of equity with the Capital Asset Pricing Model: Re = Rf + beta x (Rm - Rf). Rf is the risk-free rate, and in the US, CFI uses the yield on the 10-year Treasury bond. Beta is the levered equity beta, a measure of how volatile a stock's returns are compared with the whole market. Rm is the annual return of the stock market.

The cost of equity isn't a bill anyone sends you. CFI calls it an implied cost, or an opportunity cost of capital: the return an investor needs to make up for the risk of holding the stock. If you've got the return data in Excel, CFI says beta can be calculated with the SLOPE function. The extra yield the stock market earns over the risk-free rate is the equity risk premium, and CFI notes that banks often take it from publications by Morningstar or Kroll.

There's a more thorough route to beta too. CFI describes taking the betas of comparable public companies, stripping out the effect of each one's debt to get an unlevered beta, averaging them, then re-levering that average using the capital structure of the company you're valuing. Levered beta carries both business risk and the risk that comes from debt; unlevered beta shows the business risk on its own.

The catch: the tax shield applies to debt, not preferred shares

Here's the detail people miss. Interest payments are tax-deductible, so CFI multiplies the cost of debt by (1 - tax rate). That adjustment is called the tax shield. Preferred dividends don't get it, because they're paid out of after-tax profits. CFI's method for the debt side is short:

1. Take the weighted average current yield to maturity of all the business's outstanding debt.
2. Multiply it by one minus the tax rate.
3. Use the result as the after-tax cost of debt in the formula.
4. For preferred stock, use its dividend yield with no tax adjustment.

The tax shield is also why CFI calls debt a cheaper source of financing than equity. It doesn't stay cheaper forever, though: at some point, CFI says, the cost of issuing more debt will exceed the cost of issuing new equity.

How to calculate WACC, step by step

1. Find the market value of equity and of debt, and add them for the total.
2. Work out the cost of equity with CAPM.
3. Take the yield to maturity on debt and multiply it by (1 - tax rate).
4. Weight each cost by its share of total capital.
5. Add the weighted costs together to get WACC, then compare it with the project's IRR.

What WACC is used for: the hurdle rate

CFI says WACC works as a hurdle rate. Companies commonly use it to judge mergers and acquisitions and to model internal investments. The rule is simple: if a project's internal rate of return (IRR) is lower than WACC, the company shouldn't invest, and it may choose to buy back its own shares or pay a dividend instead. Excel's IRR function gives you the project return to hold up against it.

WACC is also the discount rate in a discounted cash flow (DCF) valuation. CFI explains that discounting unlevered free cash flow by WACC gives the company's implied enterprise value. Subtract net debt to estimate equity value, then divide by the fully diluted shares outstanding for a value per share.

One more distinction from CFI: nominal free cash flows, which include inflation, should be discounted at a nominal WACC, and real free cash flows, which exclude it, at a real WACC. Nominal is the more common of the two in practice.

Why every WACC figure is an estimate

CFI lists four limitations, and they're the reason I wouldn't treat a single WACC figure as gospel:

• It's hard to measure. Inputs like beta need analyst judgement and a realistic list of comparable companies.
• It's hard to apply to one project. WACC is usually worked out for the whole company, and a single investment may carry different risk. CFI's workaround is to add a margin of error for riskier projects.
• It relies on history. Valuation looks forward, but the equity risk premium and beta are almost always based on past data.
• It's harder for private companies, especially the cost of equity. CFI suggests the comparable company approach for beta, and the cost of debt of similarly credit-rated companies as a stand-in.

WACC vs cost of capital

The two terms get used as if they're the same thing. CFI's page on cost of capital defines it as the minimum rate of return a business must earn before generating value, made up of the cost of debt and the cost of equity. WACC is the most common way to calculate it, with each source weighted by its share of the capital structure. So cost of capital is the idea, and WACC is the usual way of putting a number on it. It's also the discount rate CFI uses for free cash flows in a DCF model.

My verdict on WACC

WACC is the bar a project has to clear. It isn't a precise fact, because nearly every input involves judgement: beta, the risk premium, which companies count as comparable. Change one and the answer moves. So I'd work it out, then test your decision with a slightly higher and a slightly lower figure. If the decision doesn't change, you can go ahead with confidence. If it flips, that's the project worth a closer look, ideally with someone who does this every day, like a virtual CFO. And if you're weighing up a bigger move, these notes on making informed financial decisions are a good companion.

Frequently asked questions

What does WACC stand for?

Weighted average cost of capital. It's a business's blended cost of capital across common shares, preferred shares and debt, with each cost weighted by its share of total capital.

Why is the cost of debt multiplied by (1 - T)?

Because interest payments are tax-deductible. CFI calls this the tax shield. Preferred dividends don't get the adjustment, because they're paid from after-tax profits.

How is the cost of equity worked out for WACC?

CFI uses the Capital Asset Pricing Model: Re = Rf + beta x (Rm - Rf), where Rf is the risk-free rate, beta is the levered equity beta and Rm is the annual return of the stock market.

How do companies use WACC to decide on a project?

As a hurdle rate. CFI says that if a project's IRR is lower than WACC, the company shouldn't invest, and may buy back shares or pay a dividend instead.

Can a private company calculate WACC?

Yes, but CFI says it's harder, especially the cost of equity. It suggests using comparable companies for beta and the cost of debt of similarly credit-rated companies.