WACC: Weighted Average Cost of Capital Explained

WACC is the number that sits at the heart of every DCF valuation and every capital budgeting hurdle rate. Get it wrong by a percentage point and your valuation moves by 10–20%. This guide covers how to calculate each component correctly — and where the real-world complications arise.

The WACC Formula

WACC = (E/V × Re) + (D/V × Rd × (1 − T)), where E = market value of equity, D = market value of debt, V = E + D, Re = cost of equity, Rd = pre-tax cost of debt, T = corporate tax rate. The weights should use market values, not book values — book values can be significantly distorted by historical cost accounting.

Cost of Equity (CAPM)

The cost of equity is estimated using CAPM: Re = Rf + β × (Rm − Rf). The risk-free rate is typically a government bond yield matching the investment horizon. Beta measures how much the equity moves relative to the market — a beta of 1.2 means 20% more volatile. The equity risk premium (Rm − Rf) varies by market; for the UK it has historically been around 4–5%. For unlisted companies, you will need to unlever a comparable listed company's beta and relever at your own capital structure.

Cost of Debt

The cost of debt is the yield to maturity on existing debt, or the rate on new borrowing. It is multiplied by (1 − T) to reflect the tax deductibility of interest. For investment-grade companies, the pre-tax cost of debt is observable from bond prices or credit spreads. For smaller companies, use the current borrowing rate.

Common Pitfalls

Using book value weights instead of market value weights. Using the coupon rate on debt rather than the yield to maturity. Applying a single WACC to projects with significantly different risk profiles — for a project materially riskier than the firm's existing business, the WACC should be adjusted upward. Ignoring the impact of capital structure changes over the investment horizon.

When Not to Use WACC

WACC assumes a constant capital structure throughout the investment horizon. For highly leveraged transactions (LBOs, project finance) where debt is paid down over time, the Adjusted Present Value (APV) method — which separates the unlevered project value from the tax shield — is more appropriate.

Further Reading

• Cost of Equity and CAPM
• Cost of Debt
• Financial Management CPD

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