Investing
How To Calculate Weighted Average Cost Of Capital
Every source of money a company uses has a price. WACC is the single blended price, weighted by how much of each source the company actually relies on.
Quick Answer
WACC = (E / V) x Re + (D / V) x Rd x (1 - T)
- E
- The market value of equity
- D
- The market value of debt
- V
- Total capital, equity plus debt
- Re
- The cost of equity, the return shareholders demand
- Rd
- The cost of debt, the interest rate the company pays
- T
- The corporate tax rate, which makes debt cheaper than it looks
Weight the cost of equity by equity's share of total capital, add the after tax cost of debt weighted by debt's share. At 60 percent equity costing 11 percent and 40 percent debt costing 6 percent with tax at 25 percent, the blended cost is 8.4 percent.
What Is Weighted Average Cost Of Capital?
Weighted average cost of capital is the average rate a company pays for all the money it uses, with each source weighted by its share of the total. It is the discount rate most often applied to a company's future cash flows.
The weighting is by market value, not book value. What matters is what investors would pay today for the equity and the debt, because that is the opportunity cost of the capital, not what the balance sheet happened to record years ago.
The tax adjustment only applies to debt. Interest is generally deductible, so each unit of interest costs the company less than a unit of profit distributed to shareholders, which have already borne tax at the company level.
That asymmetry is the whole reason debt looks cheap in this formula. At a 25 percent tax rate, debt costing 6 percent really costs 4.5 percent after the deduction, which is why the debt term carries the (1 - T) factor and the equity term does not.
The cost of equity is the hardest input to observe, because shareholders are not sent a bill. It is normally estimated from a risk free rate plus a risk premium scaled by how volatile the stock is relative to the market.
The result is a hurdle rate in the plain sense. A project expected to return less than the WACC destroys value even if it makes an accounting profit, because the capital could have been deployed elsewhere at that rate.
Because the weights are shares, they always add to one. Adding more debt raises the debt weight and lowers the equity weight, which at first pulls the blended figure down because debt is cheaper.
That pull does not continue indefinitely. Beyond some point, more debt makes both the equity and the debt more expensive, because lenders and shareholders both price in the greater chance of distress.
The classic shape is therefore a curve with a low point, and the leverage that sits at that low point is the capital structure that minimises WACC. Finding it is a judgement about the business, not something the formula states.
WACC assumes the weights stay fixed. If a company is expected to change its capital structure materially over the period being discounted, a single blended rate is an approximation, and the honest answer is to model the mix year by year.
For the running example, 600,000 of equity and 400,000 of debt give total capital of 1,000,000, so the weights are 0.6 and 0.4. Equity costs 11 percent and debt costs 6 percent before tax.
The after tax cost of debt is 6 percent times one minus 0.25, which is 4.5 percent. The weighted contribution is 0.4 times 4.5 percent, or 1.8 percent.
The weighted cost of equity is 0.6 times 11 percent, which is 6.6 percent. Adding the two contributions gives 8.4 percent.
Applied to 1,000,000 of capital, that is an annual charge of 84,000, which is the return the company must generate just to stand still in value terms.
The tax shield is worth seeing separately. On this structure the deduction on debt interest is worth 6,000 a year, which is the concrete benefit the (1 - T) term is capturing.
Formula
E / V and D / V, where V = E + D
Formula page →Market value shares, which by construction sum to one.
| Symbol | Meaning | Unit | Notes |
|---|---|---|---|
| E | Equity | currency | The market value of the equity. |
| D | Debt | currency | The market value of the debt. |
| V | Total capital | currency | Equity plus debt. |
Rd x (1 - T)
Formula page →Interest is generally deductible, so the true cost to the company is lower.
| Symbol | Meaning | Unit | Notes |
|---|---|---|---|
| Rd | Cost of debt | fraction per year | The rate the company pays on its borrowings. |
| T | Tax rate | fraction | The corporate tax rate applied to profits. |
WACC = (E / V) x Re + (D / V) x Rd x (1 - T)
Formula page →The blended hurdle rate for capital as a whole.
| Symbol | Meaning | Unit | Notes |
|---|---|---|---|
| WACC | Blended cost | fraction per year | The average rate paid across all capital. |
| Re | Cost of equity | fraction per year | The return shareholders require. |
| Rd | Cost of debt | fraction per year | The pre tax rate on borrowings. |
How To Calculate Weighted Average Cost Of Capital
- 1
Add equity and debt to get total capital
Use market values. Here 600,000 of equity plus 400,000 of debt gives 1,000,000 of total capital to weight against.
- 2
Work out each source's share
Divide each by the total. Equity is 0.6 of the capital and debt is 0.4. The two shares must add to one, which is a useful arithmetic check.
- 3
Convert the cost of debt to an after tax figure
Multiply by one minus the tax rate. Debt at 6 percent with tax at 25 percent costs 4.5 percent, because the interest reduces taxable profit.
- 4
Weight each cost by its share and add
Equity contributes 0.6 times 11 percent, which is 6.6 percent. Debt contributes 0.4 times 4.5 percent, which is 1.8 percent. Together they give 8.4 percent.
- 5
Apply it as a hurdle rate
On 1,000,000 of capital the annual charge is 84,000. Any project returning less than 8.4 percent is consuming value rather than creating it, whatever the accounts say.
Examples
Example 1: A company funded 60 percent by equity
- equityValue
- 600000
- debtValue
- 400000
- costOfEquity
- 11
- costOfDebt
- 6
- taxRate
- 25
| Step | Calculation | Result |
|---|---|---|
| Total capital | 600000 + 400000 | 1000000 |
| Equity weight | 600000 / 1000000 | 0.6 |
| After tax cost of debt | 0.06 x (1 - 0.25) | 0.045 |
| Weighted equity cost | 0.6 x 0.11 | 0.066 |
| Weighted average cost | 0.066 + 0.4 x 0.045 | 0.084 |
Result: The weighted cost is 0.084, or 8.4 percent. Applied to 1000000 of capital that is 84,000 a year, and the tax shield on the debt is worth 6,000 of that.
Example 2: The same company shifting to more debt
- equityValue
- 400000
- debtValue
- 600000
- costOfEquity
- 13
- costOfDebt
- 7
- taxRate
- 25
| Step | Calculation | Result |
|---|---|---|
| Total capital | 400000 + 600000 | 1000000 |
| Equity weight | 400000 / 1000000 | 0.4 |
| After tax cost of debt | 0.07 x (1 - 0.25) | 0.0525 |
| Weighted equity cost | 0.4 x 0.13 | 0.052 |
| Weighted average cost | 0.052 + 0.6 x 0.0525 | 0.0835 |
Result: Heavier leverage gives 0.0835, marginally lower, even though both costs rose. The gain is small because the equity and debt costs moved against the change in weights.
Calculator
Weighted average cost of capital
8.40%
- Total capital
- $1,000,000.00
- Equity weight
- 60.00%
- After tax cost of debt
- 4.50%
- Annual capital charge
- $84,000.00
Values update as you type. This calculator covers the single scenario its formula assumes — see Common Mistakes for what it leaves out.
Prefer a full-width tool? Open the Weighted Average Cost Of Capital calculator page.
Common Mistakes
Using book values from the balance sheet instead of market values
The weights must reflect what the capital is worth today.
Applying the tax factor to equity as well as debt
Only interest is generally deductible, so only the debt term carries (1 - T).
Using the coupon on old debt as the cost of debt
The relevant rate is what the company would pay to borrow now.
Treating the result as a forecast rather than a hurdle
WACC is the rate cash flows must beat, not a prediction of return.
Forgetting that both input costs rise with leverage
Holding them fixed while shifting weights makes heavier debt look free.
Mixing rates quoted over different periods
All the costs must be annual if the result is an annual hurdle rate.
Applying one company's WACC to a project with materially different risk, which systematically underprices risky ventures.
Applying one company's WACC to a project with materially different risk, which systematically underprices risky ventures.
FAQ
Why is the debt cost adjusted for tax but not the equity cost?
Interest is generally deductible against taxable profit, so each unit of interest costs the company less than a unit of profit paid out. Dividends are paid from profit that has already borne tax, so the equity cost needs no adjustment.
Should I use book value or market value for the weights?
Market value. WACC measures the opportunity cost of capital today, and book values reflect historical accounting rather than what investors would currently pay.
How do I estimate the cost of equity?
It is not directly observable, so it is normally estimated as a risk free rate plus a risk premium scaled by the stock's sensitivity to the market. Different models give different answers, which is why the input is worth stress testing.
Does more debt always lower WACC?
Only up to a point. Initially cheaper debt replaces expensive equity, but eventually both lenders and shareholders charge more for the extra risk, and WACC turns back upward.
What is WACC used for in practice?
Chiefly as the discount rate for valuing a business or a project. Cash flows discounted at a rate below the true cost of capital will be valued too highly.
Can WACC be negative or zero?
In ordinary circumstances no, because both sources of capital carry a positive required return. A figure near zero usually signals an input error rather than a real result.
References
- [1]Wikipedia, Weighted average cost of capital — https://en.wikipedia.org/wiki/Weighted_average_cost_of_capital
- [2]Corporate Finance Institute, Cost of capital — https://corporatefinanceinstitute.com/resources/accounting/cost-of-capital/
- [3]Wikipedia, Capital structure — https://en.wikipedia.org/wiki/Capital_structure