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Weighted average cost of capital

When and how should weighted average cost of capital be applied?

AccessibleStrategicProgram / project2 min read

Contents

A firm’s ‘weighted average cost of capital’ (or WACC) is a financial metric used to measure the cost of capital to a firm.

Weighted average cost of capital (WACC) estimates the return required collectively by a company’s debt and equity providers. Each source is weighted by its share of the target financing structure, with the debt cost adjusted for the tax treatment of interest.

When to use it

Select a discount rate for valuing a business or a project with risk comparable to the company’s existing operations.

Test whether an investment is expected to earn more than the capital required to finance it.

Origins

Ferry Allen used the term “cost of capital” in an academic study in 1954 and examined how different combinations of debt and equity affect financing cost. Franco Modigliani and Merton Miller gave capital-structure analysis a stronger theoretical foundation in their 1958 paper “The Cost of Capital, Corporation Finance and the Theory of Investment.” WACC developed as a practical way to combine the required returns of the principal funding sources.

What it is

Debt holders require interest and repayment; equity holders require compensation for bearing residual risk through dividends and capital appreciation. WACC combines those required returns using market-value weights:

WACC = (E ÷ V × Re) + (D ÷ V × Rd × (1 − Tc))

where:

Re is the required return on equity.
Rd is the current pre-tax cost of debt.
E is the market value of equity.
D is the market value of interest-bearing debt.
V is E + D, the total market value of financing.
Tc is the applicable marginal corporate tax rate.

WACC is an opportunity-cost benchmark, not simply the interest rate paid by the company. A project creates financial value only when its risk-adjusted return exceeds the capital cost. Use market values and a target sustainable capital structure where possible, because historical book weights may not represent the financing relevant to future decisions.

How to use it

Gryphon Conglomerate is evaluating investments. Its current financing is 80 per cent equity requiring a 25 per cent return and 20 per cent long-term debt costing 6 per cent. The marginal tax rate is 30 per cent. If financing were 100 per cent equity, WACC would be 25 per cent. With the current mix:

WACC = (0.80 × 0.25 ÷ 1.00) + (0.20 × 0.06 × (1 − 30 per cent) ÷ 1.00) = 0.20 + 0.0084 = 0.2084, or 20.84 per cent

On those assumptions, an initiative needs an expected return above 20.84 per cent. Projects returning 15–18 per cent would not clear the hurdle.

Comparable firms use about 50 per cent debt, so Gryphon models that structure:

WACC = (0.50 × 0.25 ÷ 1.00) + (0.50 × 0.06 × (1 − 30 per cent) ÷ 1.00) = 0.125 + 0.021 = 0.146, or 14.6 per cent

At that estimated rate, projects returning 15–18 per cent may create value if their risk matches the assumptions.

Gryphon then models a hypothetical structure with 80 per cent debt:

WACC = (0.20 × 0.25 ÷ 1.00) + (0.80 × 0.06 × (1 − 30 per cent) ÷ 1.00) = 0.05 + 0.0336 = 0.0836, or 8.36 per cent

This mechanical decline is not a free financing benefit. More leverage raises default risk, so lenders and shareholders may demand higher returns and the tax shield may become less certain. WACC should therefore reflect a feasible target structure, not the debt proportion that minimises a spreadsheet result.

Estimate debt cost from current market borrowing rates for comparable maturity and risk, not merely the coupon on old debt. Equity cost can be estimated with the capital asset pricing model, a dividend approach or a risk-premium build-up. For example, a 10-year government bond yield of 4 per cent plus a 5 per cent market risk premium implies a 9 per cent equity cost before company-specific adjustments.

Use one company-wide WACC only for projects with risk similar to the existing business. A new country, technology or business model may require a different discount rate. At minimum, run 1 sensitivity case around each material input.

Top practical tip

Match precision to the decision. An estimate within 1–2 per cent may be adequate when project cash-flow uncertainty is much larger than 1–2 per cent. Show a sensitivity range and focus scrutiny on market weights, equity cost, debt spread and project risk.

Top pitfall

Do not treat WACC as fixed or universal. Leverage changes required returns, CAPM inputs are estimates and a corporate average can accept risky projects while rejecting safer ones. Re-estimate material assumptions and use a risk-appropriate rate.