WACC (Weighted Average Cost of Capital)
The blended required return a company must generate to satisfy both its debt and equity holders, weighted by their respective proportions in the capital structure. Used as the discount rate in a DCF.
Why WACC (Weighted Average Cost of Capital) matters in interviews
WACC is the discount rate in every unlevered DCF, so an interviewer probing it is really asking whether your valuation rests on anything or whether you plugged in 10% because it looked reasonable. It also opens onto CAPM, unlevering and relevering beta, and why the cost of debt is tax-affected — a rich seam of follow-up questions.
How it works in practice
WACC = (E/V) x cost of equity + (D/V) x cost of debt x (1 − tax rate), where E is market value of equity, D is market value of debt and V is E + D.
Cost of equity comes from CAPM: risk-free rate + levered beta x equity risk premium. With a 4.2% risk-free rate, a levered beta of 1.2 and a 5.5% equity risk premium, cost of equity is 4.2% + 1.2 x 5.5% = 10.8%.
Continuing that example: the company is 70% equity and 30% debt by market value, pre-tax cost of debt is 6.0% and the tax rate is 25%. WACC = 0.7 x 10.8% + 0.3 x 6.0% x 0.75 = 7.56% + 1.35% = 8.9%.
Beta is usually taken from comparable companies, unlevered to strip out each peer's capital structure, averaged, then relevered at the target's own capital structure. That is where the "unlever and relever beta" follow-up comes from.
What candidates get wrong
- Using book values of debt and equity instead of market values.
- Forgetting the (1 − tax rate) factor on debt. Interest is tax-deductible, which is exactly why leverage is cheap and why LBOs work.
- Using the company's own historical beta when it is thinly traded or has recently changed its capital structure. Peer-derived beta is more defensible.
- Applying one WACC to a conglomerate. Divisions with different risk profiles need different discount rates.
WACC (Weighted Average Cost of Capital): frequently asked questions
Why is the cost of debt multiplied by (1 − tax rate)?
Because interest expense is tax-deductible. A company paying 6% on its debt at a 25% tax rate bears an effective after-tax cost of 4.5%, since the interest reduces taxable income. The tax shield is the reason debt is cheaper than equity beyond just being senior in the capital structure.
Does WACC always fall as you add debt?
No. Debt is cheaper than equity, so initially WACC falls. But as leverage rises, both the cost of debt and the cost of equity increase to compensate for financial distress risk, and beyond an optimal point WACC rises again. The relationship is U-shaped, not monotonic.
Go deeper
This term comes up constantly in valuation interviews and on the desk.
DCF interview questions guideRelated Valuation terms
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