Weighted average cost of capital

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 × R_e) + (D ÷ V × R_d × (1 − T_c))

where:

• R_e is the required return on equity.
• R_d 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.
• T_c 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.