Weighted average cost of capital (WACC)

In simple terms

A company is funded by shareholders and lenders, and each expects a return. The weighted average cost of capital (WACC) is the average return the company must earn on its capital to satisfy both, weighted by how much each provides.

WACC is the discount rate for cash flows that belong to everyone who funded the business, and the benchmark a business's returns on capital must beat to create value, as the ROCE lesson explains.

The after-tax cost of debt

Interest is usually deductible when calculating taxable profit, so each rupee of interest reduces the tax bill. The cost of debt to the company is therefore lower than the interest rate:

Use the rate the company would pay to borrow today for the long term, not necessarily the rate on old loans. A rough estimate is the interest expense divided by average borrowings, checked against current borrowing costs for similar companies.

A worked example

Which weights to use

• Market values, not book values, where possible: shareholders' required return applies to what their shares are worth today, not to historical book equity.
• A target or long-run structure, not a temporary one. If a company is about to repay most of its debt, today's weights will not describe its future.
• Consistency with the cash flows. If you include lease liabilities in debt, treat lease payments consistently in the cash flows, as the EV lesson explains.

WACC or cost of equity?

The discount rate must match the cash flows being discounted.

Mixing them, for example discounting cash flow to equity at WACC, produces the wrong answer. The DCF lesson uses free cash flow to the firm and WACC.

Why more cheap debt does not keep lowering WACC

Debt costs less than equity, and it gets a tax deduction. So it seems that replacing equity with debt should always lower WACC. Up to a point it can. But as debt rises:

• Shareholders' risk rises. More of the profit goes to interest first, so equity returns swing more. Shareholders require a higher return.
• Lenders' risk rises. They charge higher interest.
• The risk of financial distress rises, with its own costs: lost customers, lost staff, forced asset sales.

Common errors

• Using book values of equity that are far from market values.
• Forgetting the tax deduction on interest.
• Using a cost of debt below the risk-free rate, which makes no sense for a company.
• Applying WACC to banks, whose debt is part of operations; value banks on equity cash flows at the cost of equity.
• Mismatching cash flows and rates.

Why it matters

WACC links a company's financing to its valuation and to the returns it must earn. It is the hurdle every investment must clear, and the rate used in most DCF valuations of whole businesses. Small changes in it change valuations a lot, so understanding how it is built, and how uncertain it is, matters.

Limitations

WACC inherits all the uncertainty of the cost of equity, and adds estimates of the cost of debt and the right capital structure. It assumes the funding mix stays roughly constant. The tax rate and borrowing costs used in the examples here are illustrative assumptions, not current figures.

Common mistakes

• Treating WACC as a precise number.
• Assuming more debt always lowers WACC.
• Discounting equity cash flows at WACC, or firm cash flows at the cost of equity.

Try it yourself

1. Choose a listed company with some debt.
2. Find its market capitalisation and borrowings, and calculate the weights of equity and debt.
3. Estimate its cost of equity from the previous lesson, and its cost of debt from interest expense divided by average borrowings.
4. Calculate WACC, then recalculate with a cost of equity two points higher. How much does WACC change?