WACC (Weighted Average Cost of Capital)
The blended return a company must earn to satisfy everyone funding it: the cost of equity weighted by equity market value, plus the after-tax cost of debt weighted by debt market value. It is the discount rate for unlevered free cash flow in a DCF, because those cash flows belong to debt and equity holders together. Use market values for the weights, never book.
WACC (Weighted Average Cost of Capital) · the mechanism
30 sec read
Build a discount rate from its parts and name where every input came from.
Where it comes up. A VP goes down your discount rate line by line and asks where each input came from. "Bloomberg" is not an answer to any of them.
Cost of equity, through CAPM
Risk-free rate plus levered beta times the equity risk premium. The risk-free rate is the current government yield at a maturity matching your forecast. Beta comes from comparable companies, unlevered and relevered at your target capital structure rather than lifted raw off a screen.
Cost of debt, after tax
What the company would pay to borrow today, not the coupon on debt raised years ago. Read it off traded bonds, or build it from the credit rating, or synthesise a rating from interest coverage. Multiply by one minus the tax rate, because interest is deductible.
Weight by market values
Equity weight is market capitalisation, never book equity. Debt weight is market value of debt, though book is an acceptable proxy for bank debt trading near par. Using book equity is the single most common error and it can move the answer by points.
Worked through
Risk-free 4.0%, ERP 5.5%, relevered beta 1.2, pre-tax cost of debt 6.5%, tax 25%, equity $3bn, debt $1bn.
- Cost of equity
- 4.0% + 1.2 × 5.5% = 10.6%
- After-tax cost of debt
- 6.5% × (1 − 0.25) = 4.9%
- Weights
- Equity 75%, debt 25%
- WACC
- 0.75 × 10.6% + 0.25 × 4.9% = 9.2%
A 9.2% WACC. Note how little the debt does: at 25% of the structure and 4.9% after tax, it pulls the blended rate down by about 1.4 points against an all-equity company.
Check yourselfThe company adds debt until it is 60% of the capital structure. Does WACC keep falling?
Answer once you have one →
No. Debt is cheaper, so WACC falls at first. But rising leverage raises the risk to equity holders, which raises beta and therefore the cost of equity, and past some point it raises the cost of debt too as the rating deteriorates. WACC is a U-shape: it falls, bottoms out, and rises. Saying "debt is cheaper so more debt is better" is the answer being screened for.
Be able to say this back next week
- Built cost of equity through CAPM and named the source of every input
- Used the cost of debt today, after tax, rather than a historical coupon
- Weighted by market values, and said why book equity is wrong
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.
Where WACC (Weighted Average Cost of Capital) comes up
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DCF interview questions guideRelated Valuation terms
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