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Weighted Average Cost of Capital (WACC)

Calculates a firm's average cost of financing, considering both debt and equity, weighted by their proportion in the capital structure.

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W A C C = (\frac{E}{V}) \cdot R_{e} + (\frac{D}{V}) \cdot R_{d} \cdot (1 - T_{c})

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Core idea

Overview

The Weighted Average Cost of Capital (WACC) represents the average rate of return a company expects to pay to all its security holders (debt and equity) to finance its assets. It is a critical metric used in capital budgeting to discount future cash flows of potential projects, ensuring that the project's expected return exceeds the cost of financing it. WACC reflects the riskiness of a company's overall operations and its capital structure.

When to use: Apply WACC as the discount rate for evaluating new investment projects, particularly when the project's risk profile is similar to the company's existing operations. It's also used in company valuation (e.g., Discounted Cash Flow models) and for assessing the overall financial health and cost of capital for a firm. Ensure market values are used for equity and debt components.

Why it matters: WACC is fundamental for making sound capital budgeting decisions, as it provides the minimum acceptable rate of return a project must generate to create value for shareholders. A well-calculated WACC helps companies allocate capital efficiently, optimize their capital structure, and ultimately enhance shareholder wealth.

Symbols

Variables

E = Market Value of Equity, D = Market Value of Debt, V = Total Market Value of Firm, $R_{e}$ = Cost of Equity, $R_{d}$ = Cost of Debt

E

Market Value of Equity

D

Market Value of Debt

V

Total Market Value of Firm

R_{e}

Cost of Equity

R_{d}

Cost of Debt

T_{c}

Corporate Tax Rate

WACC

Weighted Average Cost of Capital

Walkthrough

Derivation

Formula: Weighted Average Cost of Capital (WACC)

WACC represents the average cost of financing a company's assets, weighted by the proportion of each component (equity and debt) in its capital structure.

The company's capital structure (debt-to-equity ratio) remains constant.
Market values are used for equity and debt, not book values.
The corporate tax rate is constant and applicable to interest payments.

Identify Capital Components and Their Costs:

A company typically finances its operations through equity (e.g., common stock) and debt (e.g., bonds). Each component has an associated cost: $R_{e}$ for equity (return required by shareholders) and $R_{d}$ for debt (interest rate paid to lenders).

Cost of Equity (R_{e}), Cost of Debt (R_{d})

Determine Market Value Weights:

The total market value of the firm ( $V$ ) is the sum of the market value of equity ( $E$ ) and the market value of debt ( $D$ ). The weights are the proportion of equity ( $E / V$ ) and debt ( $D / V$ ) in the total capital structure.

V = E + D ⟹ \frac{E}{V} and \frac{D}{V}

Account for the Tax Shield on Debt:

Interest payments on debt are typically tax-deductible. This creates a 'tax shield' that reduces the effective cost of debt. $T_{c}$ is the corporate tax rate, so the after-tax cost of debt is $R_{d}$ multiplied by $(1 - T_{c})$ .

R_{d} \cdot (1 - T_{c})

Combine Weighted After-Tax Costs:

The WACC is calculated by multiplying the cost of each capital component by its respective market value weight and then summing these weighted costs. The equity component is weighted by $E / V$ and multiplied by $R_{e}$ . The debt component is weighted by $D / V$ and multiplied by its after-tax cost, $R_{d} (1 - T_{c})$ .

W A C C = (\frac{E}{V}) \cdot R_{e} + (\frac{D}{V}) \cdot R_{d} \cdot (1 - T_{c})

Result

W A C C = (\frac{E}{V}) \cdot R_{e} + (\frac{D}{V}) \cdot R_{d} \cdot (1 - T_{c})

Source: Ross, Westerfield, & Jaffe, Corporate Finance, 12th Edition, McGraw-Hill Education.

Free formulas

Rearrangements

Solve for $E$

WACC: Make E (Market Value of Equity) the subject

E = V \cdot \frac{W A C C - ( \frac{D}{V} ) \cdot R _{d} \cdot ( 1 - T _{c} )}{R _{e}}

To make $E$ the subject, isolate the equity component term, then multiply by $V$ and divide by $R_{e}$ .

Difficulty: 3/5

Solve for $D$

WACC: Make D (Market Value of Debt) the subject

D = V \cdot \frac{W A C C - ( \frac{E}{V} ) \cdot R _{e}}{R _{d} \cdot ( 1 - T _{c} )}

To make $D$ the subject, isolate the debt component term, then multiply by $V$ and divide by $R_{d} (1 - T_{c})$ .

Difficulty: 3/5

Solve for $V$

WACC: Make V (Total Market Value of Firm) the subject

V = \frac{E \cdot R _{e} + D \cdot R _{d} \cdot ( 1 - T _{c} )}{W A C C}

To make $V$ the subject, multiply both sides by $V$ , then divide by WACC, assuming $V = E + D$ is used to simplify the fractions.

Difficulty: 3/5

Solve for $R_{e}$

WACC: Make $R_{e}$ (Cost of Equity) the subject

R_{e} = \frac{W A C C - ( \frac{D}{V} ) \cdot R _{d} \cdot ( 1 - T _{c} )}{( \frac{E}{V} )}

To make $R_{e}$ the subject, isolate the term containing $R_{e}$ and then divide by its coefficient $(E / V)$ .

Difficulty: 2/5

Solve for $R_{d}$

WACC: Make $R_{d}$ (Cost of Debt) the subject

R_{d} = \frac{W A C C - ( \frac{E}{V} ) \cdot R _{e}}{( \frac{D}{V} ) \cdot ( 1 - T _{c} )}

To make $R_{d}$ the subject, isolate the term containing $R_{d}$ and then divide by its coefficient $(D / V) (1 - T_{c})$ .

Difficulty: 2/5

Solve for $T_{c}$

WACC: Make $T_{c}$ (Corporate Tax Rate) the subject

T_{c} = 1 - \frac{W A C C - ( \frac{E}{V} ) \cdot R _{e}}{( \frac{D}{V} ) \cdot R _{d}}

To make $T_{c}$ the subject, isolate the term $(1 - T_{c})$ , then solve for $T_{c}$ .

Difficulty: 3/5

The static page shows the finished rearrangements. The app keeps the full worked algebra walkthrough.

Visual intuition

Graph

The graph forms a hyperbolic curve because the total market value of the firm appears in the denominator, meaning the curve approaches the axes without ever touching them. For a finance student, this shape illustrates that as the total market value of the firm increases, the weighted average cost of capital decreases, reflecting how larger firms may experience a lower relative cost of financing. The most important feature of this curve is that the weighted average cost of capital never reaches zero, which signifies that a firm will always face some cost of financing regardless of how large its total market value becomes.

Graph type: hyperbolic

Why it behaves this way

Intuition

The WACC can be visualized as a blended financial average, where the costs of equity and debt are combined in proportion to their market values in the company's capital structure, with the cost of debt being reduced the relation.

WACC

The average rate of return a company expects to pay to all its security holders (debt and equity) to finance its assets.

The minimum return a project must generate to cover its financing costs, acting as a "hurdle rate."

E

The total market value of a company's equity (e.g., shares outstanding multiplied by current market share price).

Represents the market's valuation of the ownership portion of the company's capital.

D

The total market value of a company's interest-bearing debt (e.g., market value of bonds, loans).

Represents the market's valuation of the borrowed portion of the company's capital.

V

The total market value of the firm's financing, calculated as the sum of the market value of equity (E) and the market value of debt (D).

The total market value of all long-term capital used by the company.

E/V

The proportion of the company's total capital structure that is financed by equity.

The relative importance or "weight" of equity in the overall cost calculation.

D/V

The proportion of the company's total capital structure that is financed by debt.

The relative importance or "weight" of debt in the overall cost calculation.

R_{e}

The cost of equity, representing the return required by equity investors to compensate for the risk of their investment.

The expected rate of return shareholders demand for holding the company's stock.

R_{d}

The cost of debt, representing the current market interest rate a company would pay on new debt.

The effective interest rate lenders charge the company before considering tax benefits.

Signs and relationships

(1 - T_c): This term accounts for the "tax shield" benefit of debt. Interest payments on debt are tax-deductible, reducing a company's taxable income and thus its tax liability. Multiplying the cost of debt ( $R_{d}$ ) by (1 - $T_{c}$ )

Free study cues

Insight

Canonical usage

All financial rates (cost of equity, cost of debt, tax rate) and the resulting WACC are dimensionless, typically expressed as decimals for calculation and often reported as percentages.

Common confusion

The most common mistake is mixing percentages and decimals in calculations (e.g., using 10 for 10% instead of 0.10). All rates must be consistently converted to decimals before applying them in the formula.

Dimension note

All components representing costs ( $R_{e}$ , $R_{d}$ ), tax rates ( $T_{c}$ ), and capital structure proportions (E/V, D/V) are dimensionless ratios or rates. The final WACC is also a dimensionless rate.

Unit systems

$E$ currency - Market value of equity. Must be in the same currency unit as D and V.

$D$ currency - Market value of debt. Must be in the same currency unit as E and V.

$V$ currency - Total market value of the firm (E + D). Must be in the same currency unit as E and D.

$R_{e}$ dimensionless - Cost of equity. Must be expressed as a decimal (e.g., 0.10 for 10%) for calculation.

$R_{d}$ dimensionless - Cost of debt. Must be expressed as a decimal (e.g., 0.05 for 5%) for calculation.

$T_{c}$ dimensionless - Corporate tax rate. Must be expressed as a decimal (e.g., 0.25 for 25%) for calculation.

WACCdimensionless - Weighted Average Cost of Capital. The result will be a decimal, often converted to a percentage for reporting.

One free problem

Practice Problem

A company has market value of equity (E) of $500 mi l l i o nan d ma r k e t v a l u eo f d e b t (D) o f$ 200 million. The cost of equity ( $R_{e}$ ) is 12%, the cost of debt ( $R_{d}$ ) is 6%, and the corporate tax rate ( $T_{c}$ ) is 30%. Calculate the company's WACC.

Market Value of Equity500000000 $

Market Value of Debt200000000 $

Total Market Value of Firm700000000 $

Cost of Equity0.12 %

Cost of Debt0.06 %

Corporate Tax Rate0.3 %

Solve for: WACC

Hint: Remember to calculate the total firm value (V) first and apply the tax shield to the cost of debt.

The full worked solution stays in the interactive walkthrough.

Where it shows up

Real-World Context

A large corporation uses its WACC to determine if a proposed acquisition target is financially viable by discounting the target's projected cash flows.

Study smarter

Tips

Always use market values for E (equity) and D (debt), not book values.
The cost of debt ( $R_{d}$ ) should be after-tax because interest payments are tax-deductible.
The cost of equity ( $R_{e}$ ) can be estimated using models like the Capital Asset Pricing Model (CAPM).
WACC assumes a constant capital structure and risk profile for the projects being evaluated.

Avoid these traps

Common Mistakes

Using book values instead of market values for equity and debt.
Forgetting to apply the tax shield to the cost of debt.
Using WACC to discount projects with significantly different risk profiles than the company's average.

Common questions

Frequently Asked Questions

WACC represents the average cost of financing a company's assets, weighted by the proportion of each component (equity and debt) in its capital structure.

Apply WACC as the discount rate for evaluating new investment projects, particularly when the project's risk profile is similar to the company's existing operations. It's also used in company valuation (e.g., Discounted Cash Flow models) and for assessing the overall financial health and cost of capital for a firm. Ensure market values are used for equity and debt components.

WACC is fundamental for making sound capital budgeting decisions, as it provides the minimum acceptable rate of return a project must generate to create value for shareholders. A well-calculated WACC helps companies allocate capital efficiently, optimize their capital structure, and ultimately enhance shareholder wealth.

Using book values instead of market values for equity and debt. Forgetting to apply the tax shield to the cost of debt. Using WACC to discount projects with significantly different risk profiles than the company's average.

A large corporation uses its WACC to determine if a proposed acquisition target is financially viable by discounting the target's projected cash flows.

Always use market values for E (equity) and D (debt), not book values. The cost of debt ($R_d$) should be after-tax because interest payments are tax-deductible. The cost of equity ($R_e$) can be estimated using models like the Capital Asset Pricing Model (CAPM). WACC assumes a constant capital structure and risk profile for the projects being evaluated.

Yes. Open the Weighted Average Cost of Capital (WACC) equation in the Equation Encyclopedia app, then tap "Copy Excel Template" or "Copy Sheets Template".

References

Sources

Principles of Corporate Finance by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
Corporate Finance by Stephen A. Ross, Randolph W. Westerfield, and Jeffrey Jaffe
Wikipedia: Weighted average cost of capital
Corporate Finance (12th ed.) by Ross, Westerfield, and Jaffe
Principles of Corporate Finance (13th ed.) by Brealey, Myers, and Allen
Richard A. Brealey, Stewart C. Myers, Franklin Allen. Principles of Corporate Finance. 13th ed. McGraw-Hill Education, 2020.
Stephen A. Ross, Randolph W. Westerfield, Jeffrey F. Jaffe. Corporate Finance. 12th ed. McGraw-Hill Education, 2019.
Ross, Westerfield, & Jaffe, Corporate Finance, 12th Edition, McGraw-Hill Education.

Weighted Average Cost of Capital (WACC)

Overview

Variables

Derivation

Identify Capital Components and Their Costs:

Determine Market Value Weights:

Account for the Tax Shield on Debt:

Combine Weighted After-Tax Costs:

Rearrangements

Graph

Intuition

Insight

Practice Problem

Real-World Context

Tips

Common Mistakes

Related Formulas

Capital Asset Pricing Model (CAPM)

Cost of Debt

Net Present Value (NPV)

Frequently Asked Questions

Sources