Weighted-average cost of capital (WACC)

What does the cost of capital measure?

A company’s cost of capital is the return its investors require for supplying money. It is the company’s required rate of return on its own investments: a project that earns less than this destroys value, because shareholders could earn their required return elsewhere. When a company has run out of positive-NPV projects, the right move is to return cash to investors.

Because a company uses both debt and equity, its cost of capital is a blend of the two. Debt is the cheaper source for two reasons. Lenders hold a priority, fixed claim on cash flows (sometimes backed by collateral), so they take less risk than shareholders, who hold a residual claim. And in most countries interest is tax deductible, while dividends are not.

The blend is the weighted-average cost of capital, and it is the number used as $r$ in NPV and as the hurdle rate for IRR, after adjusting for the risk of a particular project.

How do you calculate WACC?

The weighted-average cost of capital (WACC) weights each source of financing by its share of the total.

$$WACC = w_d\, r_d\,(1 - t) + w_p\, r_p + w_e\, r_e$$

Here $w_d$, $w_p$ and $w_e$ are the weights of debt, preferred stock and common equity (they add to 100%), $r_d$ is the pre-tax cost of debt , $r_p$ the cost of preferred stock, $r_e$ the cost of equity and $t$ the marginal tax rate. Most companies have no preferred stock, so the middle term is usually absent.

WACCthe blended return investors require

• Debt Memorize cheaper: priority claim, sometimes secured
  • Pre-tax cost of debt yield on similar new borrowing
  • Times (1 − t) where interest is deductible
• Equity Memorize a residual claim, so it costs more
  • Cost of equity an input here; estimated later
  • No tax adjustment distributions are not deductible
• Other financing Know the idea only if the company has it
  • Preferred stock its own weight and cost
  • Non-controlling interests likewise
• Weights Use it how much of each is used
  • Market values the usual choice
  • Management target often stated in book terms

The debt cost is multiplied by $(1 - t)$ because interest saves tax. That product is the after-tax cost of debt .

$$r_d\,(1 - t)$$

What goes into each input?

Cost of debt. This is what lenders require on the company’s borrowing. The yield on its existing bonds or loans is a good starting point; for a forward-looking figure, use the rates that similar companies have recently paid on new debt. Apply $(1 - t)$ only where interest is deductible.

Cost of equity. This is what shareholders require. It is always higher than the cost of debt, because equity ranks last and its distributions are not tax deductible. There is no contractual rate to observe, so it has to be estimated. In this module it is given to you as an input. Models for estimating it come later in the curriculum (equity valuation and portfolio management), so do not try to derive it here.

Other financing. If the company also has preferred stock or non-controlling interests, each gets its own weight and its own cost. Preferred dividends are not deductible, so they take no tax adjustment.

Market value or book value weights?

Use market value weights : the current market value of each source of capital as a share of the total. Investors’ opportunity cost reflects what their holdings are worth today. Book value weights come from the balance sheet and reflect historical prices, which can be far from current values, especially for equity. The alternative to market weights is the company’s target weights, which management often states in book terms (the final lesson of this module covers targets).

How do you read WACC?

WACC is the bar a project of average risk must clear. A company creates shareholder value by earning a higher return on its investments and by financing with a mix that lowers WACC. The second part is harder than it sounds, because the cost of debt and the cost of equity are set by investors in financial markets, not chosen by management. Managers can influence them (by changing risk), but cannot set them.

Managers have a second aim when they choose the financing mix: where it is practical and economical, they match the life of the financing to the life of the assets it pays for, so long-lived plant is funded with long-term debt and equity rather than short-term loans that must keep being rolled over.

The tax rate moves WACC through the debt term only.

A change in any one cost moves WACC by that change times its weight, so a one-point rise in the cost of equity lifts WACC by 0.65 points here, and a one-point rise in the pre-tax cost of debt lifts it by only 0.35 × 0.75 = 0.26 points.

Go deeper Adjusting WACC for project risk

WACC describes the company as a whole, so it is the right hurdle for a project that looks like the rest of the business. A riskier project (a new market, a new technology) needs a higher hurdle, and a safer one a lower hurdle. Discounting a risky project at the company’s average WACC would flatter it and could lead the company to accept projects that destroy value.

Go deeper Why internally generated cash still has a cost

Retained earnings are not free. They belong to shareholders, who could have received them as dividends and earned their required return elsewhere. So retained cash carries the cost of equity, which is why the cost-of-equity input applies whether the company raises new shares or keeps profits.

Exam tip Debt gets the (1 − t). Equity and preferred do not. Weights come from market values, and they must add to 100%.