What Is the Weighted Average Cost of Capital (WACC)?
WACC represents the average return that a company's investors, both shareholders and lenders, require for funding the business. Because a company is financed by a mix of equity and debt, its overall cost of capital is a weighted blend of what each source costs.
In valuation, WACC serves as the discount rate applied to unlevered free cash flows in a DCF, since those cash flows belong to all capital providers. A higher WACC means future cash flows are worth less today, producing a lower valuation.
Formula
The formula is WACC = (E/V x Re) + (D/V x Rd x (1 - Tc)), where E is the market value of equity, D is the market value of debt, V is E plus D, Re is the cost of equity, Rd is the cost of debt, and Tc is the tax rate. The cost of debt is multiplied by (1 - Tc) because interest payments are tax deductible, making debt cheaper on an after-tax basis.
The cost of equity is typically estimated with the capital asset pricing model, while the cost of debt is based on the yield the company would pay to borrow today. Target or industry-average capital structure weights are often used rather than the current snapshot.
Example
Take a company with $800 million of equity and $200 million of debt, so equity is 80% and debt is 20% of the $1 billion capital base. If the cost of equity is 11%, the pre-tax cost of debt is 6%, and the tax rate is 25%, then WACC = (0.80 x 11%) + (0.20 x 6% x 0.75) = 8.8% + 0.9% = 9.7%. That 9.7% would be the discount rate in a DCF of this business.
Why It Matters
WACC is the hurdle a company must clear for a project or acquisition to create value: earning returns above WACC adds value, while earning below it destroys value. It also drives valuation mechanics directly, since even a one percentage point change in WACC can move a DCF output by 15% or more.
Interviewers frequently ask how adding debt affects WACC, and the classic answer is that moderate debt lowers WACC because debt is cheaper and tax-advantaged, but excessive debt raises both the cost of debt and the cost of equity as financial risk climbs.
