WACC and the cost of capital explained

WACC, short for weighted average cost of capital, is the average rate a company must earn to satisfy everyone who funds it: lenders who expect interest and shareholders who expect a return for taking risk. It is the standard yardstick for judging whether a business creates value and the usual discount rate for valuing a company's cash flows.

The idea behind the cost of capital

Capital is not free. Borrowing has an explicit price in the form of interest. Equity has an implicit price: investors could have put the same money elsewhere, so they require a return that compensates for the risk of owning the shares. The cost of capital combines the two, weighted by how much of each the company uses.

The formula

WACC = E/(D+E) x Re + D/(D+E) x Rd x (1 - T)

The cost of debt is multiplied by (1 - T) because interest is generally tax-deductible, so the government effectively shares the cost. Dividends and share buybacks are not deductible, so the cost of equity gets no such adjustment. If a company has preferred stock, it is added as a third term with its own weight and cost.

Estimating the cost of equity

Unlike debt, the cost of equity cannot be read from a contract. The standard approach is the capital asset pricing model:

Re = Risk-free rate + Beta x Equity risk premium

The risk-free rate is typically the yield on long-term government bonds, beta measures how strongly the stock tends to move with the overall market, and the equity risk premium is the extra return investors require from stocks in general over a risk-free investment. The article on the discount rate and CAPM goes further. StocksXray uses Damodaran datasets for betas and the equity risk premium.

Example (illustrative numbers)

A company is financed 70% by equity and 30% by debt. The risk-free rate is 4%, beta is 1.0 and the equity risk premium is 5%. The company's borrowing costs 5% and its tax rate is 25%.

Re = 4% + 1.0 x 5% = 9.0%
After-tax cost of debt = 5% x (1 - 0.25) = 3.75%

WACC = 0.70 x 9.0% + 0.30 x 3.75%
     = 6.30% + 1.125%
     = 7.4% (rounded)

To create value, the company's projects must on average earn more than about 7.4% a year on the capital invested. Compare this with the company's ROIC: an ROIC of 12% would mean a healthy spread, while an ROIC of 6% would mean the business is not earning its cost of capital.

Why WACC matters so much in valuation

In a discounted cash flow model, future cash flows are converted into today's dollars using the WACC. A higher rate shrinks the present value of distant cash flows, and because much of a company's value typically sits far in the future, valuation is highly sensitive to this one number.

Moving from 6% to 10% cuts the present value of that distant cash flow by almost a third. A model that appears precise can swing widely on small changes in assumptions. This sensitivity is also one reason fair value is better expressed as a range than as a single number.

Common mistakes and limits

Using book values for the weights. The weights should reflect market values of capital, not the accounting values on the balance sheet. A company with a high stock price and modest debt may have a much lower share of debt in market terms than book terms suggest.

Believing the output is precise. Beta is an estimate based on historical price movements and can vary with the time period and index chosen. The equity risk premium is debated by practitioners and the choice of risk-free rate matters. Treat WACC as a reasonable range of a point or two, not as a measured fact.

Using one rate for everything. A company's WACC reflects its overall average risk. A new venture in an unfamiliar, riskier market should be judged against a higher rate than the company's core business.

Assuming cheap debt makes everything cheaper. Adding debt lowers WACC at first because debt is cheaper than equity, but more debt also makes the equity riskier and raises the cost of both. There is no free lunch in simply borrowing more.

Ignoring changes over time. Interest rates, risk premiums and the company's capital structure all move. A WACC computed in one environment may not be appropriate in another.

Using the wrong tax rate. Using the marginal tax rate on interest deductions is the principle, but effective rates are often used in practice. Be aware of the choice.

Where to see it on StocksXray

The fair value estimate includes a ten-year DCF as one of its three models, and the cost of capital is a central input to any such model. The site's methodology page explains how the models are blended and why the result is presented as a range, with typical model error around 40%.

Key takeaways

• WACC is the blended cost of a company's debt and equity, weighted by their market-value shares, with debt adjusted for the tax deduction on interest.
• The cost of equity is usually estimated with CAPM from the risk-free rate, beta and the equity risk premium.
• A business creates value only when its return on invested capital exceeds WACC.
• Small changes in WACC produce large changes in DCF valuation, so treat it as an estimate with a range.
• Use market values for the weights and match the rate to the risk of what is being valued.