Weighted Average Cost of Capital (WACC)

In one sentence: WACC is the average yearly price a company pays for all the money it uses, mixing the owners’ price and the lenders’ price by how much of each it has.

$\text{WACC} = \frac{E}{V} R_e + \frac{D}{V} R_d (1 - T_c)$

Read it out loud: “WACC equals E over V, times R sub e, plus D over V, times R sub d, times one minus T sub c. E is the market value of the owners' equity, D is the market value of the debt, and V is E plus D. R sub e is the return the owners require, R sub d is the interest rate on the debt, and T sub c is the tax rate. The result is a yearly percentage.”

Before you start

The ideas and signs this page uses, explained from zero. For powers of ten, Greek letters and other notation in general, see Math basics.

Weights as shares of a whole: A weight here is the fraction of the total that one source provides. If 600000 dollars out of 1000000 dollars comes from owners, their weight is 600000 divided by 1000000, which is 0.6, or 60%. The weights of all the sources add up to 1, which is the whole.
Subscripts like R sub e: A small letter written below another letter is a subscript, and it labels which quantity is meant. $R_e$ is read R sub e and means the rate for equity, while $R_d$ is R sub d, the rate for debt. The letters are labels, not numbers to multiply.
Equity and debt as sources of money: A company gets its money from equity, which is money from owners who hold shares, and from debt, which is money borrowed from lenders and repaid with interest. Both are sources of financing, meaning ways of paying for the business.
Cost of capital: The cost of capital is the return that providers of money require for giving up their money elsewhere. It is a required return that investors expect, not a bill the company receives each month.
Tax rate and tax deduction: A tax rate is the share of profit paid to the government, written as a decimal: 25% is 0.25. A tax deduction lowers the profit that is taxed. Interest is often a deduction, which is why its after-tax cost is lower than its headline rate.
Per year and percent: An interest rate of 5% per year means 5 dollars of interest on every 100 dollars borrowed over one year. Written as a decimal, 5% is 0.05, and a result of 0.075 per year is 7.5% per year.

What each symbol means

Symbol	Meaning
$\text{WACC}$	Weighted average cost of capital, the result: the average yearly return a company must earn on its money so that both owners and lenders receive what they require. Shown as a percentage per year.
$E$	The market value of equity: the total value of the company’s shares on the stock market, in dollars. It is the value of the owners’ stake today.
$D$	The market value of debt: the total amount the company owes to lenders, valued at today’s price, in dollars.
$V$	The total value of the financing, equal to E plus D, in dollars. The fractions E/V and D/V are the weights, and they always add up to 1.
$R_e$	The cost of equity: the yearly return the owners require for the risk of holding the shares, written as a percent per year.
$R_d$	The cost of debt: the yearly interest rate the company pays on its borrowing before tax, written as a percent per year.
$T_c$	The corporate tax rate: the share of profit paid as tax, written as a decimal. A rate of 25% is written 0.25.

The formula piece by piece

$\frac{E}{V}$: The weight of the owners’ money. It is the share of the total financing that comes from shares, a fraction between 0 and 1.
$R_e$: The cost of equity, the return the owners require each year. It is the price of the owners’ money before it is weighted.
$\frac{E}{V} R_e$: The owners’ part of the average: weight times price. It is the yearly cost that the owners contribute to the overall average.
$R_d (1 - T_c)$: The after-tax cost of debt. The interest rate is reduced by the tax saving, so a 5% rate with a 25% tax rate becomes 3.75%, because 1 minus 0.25 is 0.75 of the interest rate.
$\frac{D}{V} R_d (1 - T_c)$: The debt part of the average: the weight of debt times the after-tax cost of debt.
$V = E + D$: The total financing equals the market value of equity plus the market value of debt. It is the whole that the two weights divide up.
$\text{WACC} = \frac{E}{V} R_e + \frac{D}{V} R_d (1 - T_c)$: The whole formula in one sentence: WACC is the owners’ weight times their cost, plus the debt weight times the after-tax cost of debt.

What the formula is doing, and why

A company gets its money from two kinds of providers. Owners, through shares, expect a return for the risk they take. Lenders, through loans and bonds, expect interest. WACC combines these two prices into one average cost, so a single number says what the company’s money costs overall. A project that earns more than WACC adds value, while one that earns less destroys value.

Why weight them? A company that is mostly funded by owners should count the owners’ price more heavily than the lenders’ price. The weights E/V and D/V are the shares of each source in the total financing, and they always add up to 1. Multiplying each price by its share and adding the results gives an average that reflects the real mix.

Why multiply the debt cost by 1 minus the tax rate? Interest paid on debt is usually a tax-deductible expense in many countries, so the company pays less tax on its profit. The after-tax cost of debt is the interest rate times one minus the tax rate. If the tax rate is 25%, a 5% interest rate really costs 3.75%, because the tax saving covers part of it.

Why there is no tax term for equity. Dividends paid to owners are not deducted as an interest expense is, so the owners’ price is used as it stands. The cost of equity is also harder to measure than interest, because it is an expectation rather than a contract. Analysts often estimate it with a model such as the capital asset pricing model.

What WACC is used for. Companies use WACC as a hurdle rate, the minimum return a new project must earn to be worth doing. WACC rises when owners demand more, when borrowing gets more expensive or when extra debt makes the company riskier. The weights also change with the mix of financing, so the same company can have a different WACC at a different debt level.

An everyday picture

Think of a family that pays for a home renovation partly from savings and partly from a loan. The savings have a cost, the return the family could have earned elsewhere, and the loan has an interest rate. If 60% of the money came from savings that cost 10% a year and 40% came from a loan at 5% a year, the average cost of all the money lies between those two rates, closer to the savings because more of it came from there. WACC does this for a company’s mix of owners’ money and borrowed money, after allowing for the tax saving on interest.

Worked example: What does the money at Oakridge Electric Co cost on average?

Oakridge Electric Co is a made-up company that installs solar panels. Its shares are worth 600000 dollars in total on the stock market, and its debt is worth 400000 dollars. Owners expect a 10% return a year. The company pays 5% interest a year on its debt, and it pays tax at a rate of 25%. We want the WACC.

Add up the total financing. The total money in the company is the value of the shares plus the value of the debt: $V = E + D = 600000 + 400000 = 1000000\ \text{dollars}$ . Both sources are valued at what they are worth today, so together they form the whole.
Find the weights. The weight of equity is $\frac{E}{V} = \frac{600000}{1000000} = 0.6$ , and the weight of debt is $\frac{D}{V} = \frac{400000}{1000000} = 0.4$ . The two weights add to 1, because the two sources make up the whole financing.
Convert the rates to decimals. The owners’ 10% return becomes 0.10, and the 5% interest rate becomes 0.05. The formula multiplies by these rates, and multiplying by 0.10 is the same as taking 10 percent of a number.
Find the after-tax cost of debt. Interest is usually tax-deductible, so the tax saving lowers the true cost: $R_d (1 - T_c) = 0.05 \times (1 - 0.25) = 0.05 \times 0.75 = 0.0375$ . The tax term 1 minus 0.25 is 0.75, the part of each interest dollar not covered by the tax saving, so the after-tax rate is 3.75% a year.
Multiply each cost by its weight. The equity part is $0.6 \times 0.10 = 0.06$ , which is 6% a year. The debt part is $0.4 \times 0.0375 = 0.015$ , which is 1.5% a year.
Add the two parts together. $\text{WACC} = 0.06 + 0.015 = 0.075$ , which is 7.5% a year. This is the average yearly cost of Oakridge’s money after tax. A new solar project that earns more than 7.5% a year covers the required returns of both owners and lenders.

Answer: Oakridge Electric Co has a WACC of 7.5% a year. Its owners want 10% and its after-tax debt costs 3.75%, but because owners supply 60% of the money, the average lands at 7.5%.

The numbers in this example are recomputed by script every time the site is built.

Common mistakes

Using the pre-tax interest rate for debt. The formula needs the after-tax cost, $R_d (1 - T_c)$ , because the tax saving on interest lowers the true cost.
Swapping the weights. E/V goes with the cost of equity and D/V goes with the cost of debt. Swapping them gives a wrong average.
Writing the tax rate as 25 instead of 0.25. The formula needs a decimal, so 25 would make the bracket $1 - 25 = -24$ and the answer nonsense.
Treating WACC as the return every project needs. WACC is a starting hurdle, and a riskier project usually needs a higher return than the company’s average.
Using book values without thinking. The formula asks for market values where they are available, because the owners’ and lenders’ prices depend on what the financing is worth today.

Where you will meet it

Capital budgeting, where companies set a minimum return for new factories, products or acquisitions.
Discounted cash flow valuation, where WACC is the rate used to bring a company’s future cash flows back to today’s value.
Comparing financing mixes, to see whether more debt would lower the average cost of the company’s money.
Utility regulation, where regulators use a cost of capital figure when deciding how much a regulated company may earn.

Questions people ask

Why is WACC not the same as the interest rate on the company’s loans?

The loan rate is only one of the two prices. WACC also includes the owners’ required return, which is usually higher than the interest rate because shareholders carry more risk. The weighted average gives the cost of all the money together.

Why can more debt sometimes lower WACC?

After tax, debt is usually cheaper than equity, so a larger share of cheap debt pulls the average down. But more debt also makes owners and lenders demand higher returns, which can push WACC back up. The best mix balances these two effects.

Where do the inputs come from?

The market value of equity is the share price times the number of shares. The debt value comes from the balance sheet or from bond prices. The cost of equity is estimated, often with the capital asset pricing model, and the interest rate comes from the company’s loans or bonds.

Capital Asset Pricing Model (CAPM): CAPM says the return you should expect from an investment is a safe rate plus extra return for the market risk it carries, scaled by its beta.
Net Present Value (NPV): Net present value says whether a plan is worth its cost: it adds every future cash flow, shrunk back to today’s money, and the total is the plan’s value in dollars today.
Debt-to-Equity Ratio: The debt-to-equity ratio shows how much a business is funded by borrowing compared with money from its owners: a higher number means more debt.