What WACC actually measures
A company funds itself from two places: shareholders and lenders. Each wants a different return, and the company has different amounts of each. WACC blends the two into a single rate, weighted by how much of the money comes from where.
It matters because it is the hurdle. A project that returns less than WACC destroys value even if it turns a profit on paper, because the money financing it costs more than the project brings in.
A worked example
A company with $600,000 of equity and $400,000 of debt, paying 10% to shareholders and 6% to lenders, at a 25% tax rate:
| Equity side | 0.60 × 10% | 6.00% |
|---|---|---|
| Debt side, after tax | 0.40 × 6% × 0.75 | 1.80% |
| WACC | 7.80% |
Without the tax shield the same company would be at 8.40%. That 0.60 point gap is the deduction on interest doing its work, and it is worth seeing separately because it is easy to forget it is there.
Where the number gets slippery
WACC looks precise but rests on estimates. The cost of equity is not observable — it comes from a model with assumptions in it — and small changes to it move the answer a lot. Treat WACC as a range rather than a figure, and be suspicious of any valuation whose conclusion flips on a half-point of discount rate.
Frequently asked questions
What is WACC?
The weighted average cost of capital: the blended rate a company pays for the money it uses, weighting the cost of equity and the cost of debt by how much of each it has. It is the usual discount rate for valuing a project, because it is the return the project has to beat just to leave investors no worse off.
What is the WACC formula?
WACC = (E/V)·Re + (D/V)·Rd·(1 − Tc), where E is the value of equity, D the value of debt, V = E + D, Re the cost of equity, Rd the cost of debt and Tc the corporate tax rate. With E = 600,000, D = 400,000, Re = 10%, Rd = 6% and Tc = 25%, that is 6.00% + 1.80% = 7.80%.
Why is debt multiplied by (1 − Tc)?
Because interest is usually tax-deductible, so borrowing costs less after tax than the headline rate. At a 25% tax rate, 6% debt effectively costs 4.5%. That discount is called the tax shield, and it is the main reason debt looks cheaper than equity in this formula.
Why is equity more expensive than debt?
Shareholders are paid last and can lose everything, so they demand a higher return for that risk. Lenders are paid first and have legal claims, so they accept less. That is also why a company cannot simply load up on cheap debt: past a point the added risk raises the cost of both.
What values should I use for E and D?
Market values rather than book values, where you can get them. For a listed company, equity is the market capitalisation. Book values come from the balance sheet and can be far from what the market thinks the business is worth, which distorts the weights.