WACC (Weighted Average Cost of Capital)
Weighted average of the firm's after-tax cost of debt and cost of equity, weighted by their proportions in the capital structure. The discount rate that pairs with unlevered free cash flow (FCF to firm) in DCF analysis.
When to use: Use as the discount rate for unlevered FCF in firm-level DCF. WACC is also the threshold against which ROIC is judged: a sustained spread above WACC creates economic value; below WACC destroys it.
Formula
Variables
| Symbol | Name | Description | Unit |
|---|---|---|---|
| WACC | WACC | Weighted average cost of capital, as a decimal | % |
| We | Equity Weight | Equity's share of total capital, as a decimal | % |
| Re | Cost of Equity | Required return on equity, as a decimal | % |
| Wd | Debt Weight | Debt's share of total capital, as a decimal | % |
| Rd | Cost of Debt | Pre-tax cost of debt, as a decimal | % |
| TaxRate | Tax Rate | Marginal corporate tax rate, as a decimal | % |
Real-Life Examples
Example 1: Mid-Cap Industrial WACC
70% equity, 30% debt. Cost of equity 10%, pre-tax cost of debt 5%, tax rate 25%.
Given
Step-by-Step
8.13% WACC. ROIC above this threshold creates value; below destroys it. Use WACC as the discount rate when valuing the entire firm via unlevered FCF; use just cost of equity when discounting FCF-to-equity.
Frequently Asked Questions
Because interest is tax-deductible — every dollar of interest reduces taxable income, lowering the effective cost of debt by the tax rate. The "tax shield" makes debt cheaper than its stated rate.
Market-value weights for the equity portion (current market cap, not book equity); book-value weights for debt are usually fine since debt trades close to book. Mixing the two consistently produces a defensible WACC.
In Modigliani-Miller theory, WACC is constant regardless of leverage (debt is cheaper but riskier equity offsets). In practice, moderate leverage lowers WACC via the tax shield, but excessive leverage increases re sharply (financial-distress risk) and ultimately raises WACC.