Resources / Glossary / WACC

WACC.

Aka. Weighted average cost of capital
All terms

What is WACC?

WACC — the weighted average cost of capital — is the blended rate a company pays to fund itself, combining the cost of its debt and the cost of its equity in proportion to how much of each it uses. It represents the minimum return the business must earn on its assets to satisfy everyone who financed it.

In valuation, WACC is the discount rate. A discounted cash flow analysis projects a company's future free cash flows and then discounts them back to today at WACC, because that rate captures the opportunity cost of all the capital tied up in the business. A higher WACC means future cash is worth less today, and the valuation falls.

WACC is after-tax on the debt side, because interest is tax-deductible. That tax shield is why debt is a cheaper source of capital than equity — and why capital structure affects the discount rate at all.

How WACC is built

The formula weights each source of capital by its share of the total and blends the costs:

  1. Cost of equity. Usually estimated with the capital asset pricing model: the risk-free rate plus the company's beta times the equity risk premium. It is the return shareholders demand for the risk they bear.
  2. Cost of debt. The interest rate the company pays on its borrowings, then multiplied by one minus the tax rate to reflect the deductibility of interest.
  3. Weights. The proportion of equity and debt in the capital structure, ideally at market value rather than book value.
  4. Blend. WACC equals the equity weight times the cost of equity plus the debt weight times the after-tax cost of debt.

Each input is an estimate, so WACC is a range, not a precise figure. Small changes in the assumed equity risk premium or beta move it meaningfully — which is why two analysts rarely land on the same WACC for the same company.

Why WACC is contested

Because WACC drives the discount rate, and the discount rate drives the valuation, the number is where a lot of valuation disputes quietly live. Nudging WACC down by a single percentage point can lift a DCF value by a great deal, especially for businesses whose cash flows sit far in the future.

The honest treatment is to disclose the inputs and show the valuation across a range of WACCs in a sensitivity table, rather than presenting one figure as if it were observed fact. WACC is a judgment dressed as a calculation.

Frequently asked.

4 questions
01 Why is WACC used as the discount rate in a DCF?

Because it captures the cost of every dollar funding the business — debt and equity together. Free cash flow to the firm belongs to all capital providers, so discounting it at the blended cost of all that capital is internally consistent.

If you were instead valuing only the cash flow to equity holders, you would discount at the cost of equity alone, not WACC.

02 Why is the cost of debt multiplied by (1 minus the tax rate)?

Interest payments are tax-deductible, so borrowing reduces a company's tax bill. The after-tax cost of debt reflects this benefit — the effective cost to the company is lower than the headline interest rate.

This tax shield is the reason debt is a cheaper form of financing than equity, and the reason a modestly leveraged company can have a lower WACC than an all-equity one.

03 What makes WACC go up?

Rising interest rates lift the cost of debt and the risk-free rate inside the cost of equity. A higher beta — more sensitivity to the market — raises the cost of equity. Taking on riskier projects or a more volatile business mix pushes both components up.

A higher WACC compresses valuations across the board, which is why a rate-hiking environment tends to pull down the discounted value of every future cash flow at once.

04 Is there one correct WACC for a company?

No. Every input — beta, the equity risk premium, the target capital structure, the cost of debt — is an estimate, and reasonable analysts choose different ones. WACC is best understood as a defensible range, not a single right answer.

That is why disciplined valuation work presents results across a band of discount rates. Keeping each WACC assumption and its source documented alongside the model — rather than buried in a spreadsheet cell — is the kind of traceability VectorShift keeps queryable after a deal closes.

Related terms

Evaluation

Enterprise value

The value of a business to <em>all</em> capital providers — equity and debt — independent of how the company happens to be financed.

Open
Nvaluation

Net debt

Total interest-bearing debt minus cash and equivalents — the figure that <em>bridges</em> equity value and enterprise value in a deal.

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Fvaluation

Football field

A horizontal-bar chart showing the <em>range</em> of values each methodology implies — the one-page summary of where a business is worth.

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Evaluation

Equity value

The value of a business attributable to its <em>shareholders</em> alone — what is left after every debt and senior claim is satisfied.

Open
Bvaluation

Bridge to equity value

The step-by-step adjustment from <em>enterprise value</em> to equity value — netting debt, cash, and every claim that ranks ahead of common shares.

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Lvaluation

Liquidation preference

The right of preferred holders to be paid back <em>first</em> in an exit — a fixed amount off the top before common shares see a dollar.

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