A blended cost of financing, weighted by how much of each you use
WACC is what a company pays, on average, for the money it runs on — part borrowed (debt), part owned (equity). Each source is weighted by its share of the total capital, and the debt side is discounted for the tax it saves.
E is the market value of equity, D of debt, and V = E + D. Re is the cost of equity, Rd the cost of debt, and Tc the corporate tax rate. The E/V and D/V terms are simply each source's weight in the capital mix.
A worked example
Say E = $600m, D = $400m (so V = $1,000m), Re = 10%, Rd = 6%, Tc = 21%.
Without the tax shield the debt term would be 2.4% and WACC 8.4%. The deductibility of interest shaves half a point off the hurdle rate here.
The pieces, and how to read the result
| Input | What it is | Where it comes from |
|---|---|---|
| E / V | Equity weight | Market cap ÷ (market cap + debt) |
| D / V | Debt weight | Market value of debt ÷ total |
| Re | Cost of equity | Often CAPM: Rf + β(Rm − Rf) |
| Rd | Cost of debt | Yield to maturity on the debt |
| Tc | Tax rate | Marginal corporate rate |
A lower WACC signals cheaper, more efficient financing. Use market values, not book values — and remember WACC drifts as share prices, rates and the debt mix move.
The mistakes that skew a WACC
- Book values instead of market. WACC weights must use current market value of equity and debt, not balance-sheet figures.
- Over-egging the cost of equity. A wrong beta or risk premium inflates Re and can make good projects look unviable.
- Treating it as fixed. WACC changes with the capital structure; pile on debt and Re rises too as equity gets riskier, so the "cheap debt" gain reverses past a point.
Common questions
Why is debt multiplied by (1 minus the tax rate)?
Interest on debt is tax-deductible, so every dollar of interest lowers the tax bill. The (1 minus Tc) factor captures that shield: at a 21% tax rate, a 6% pre-tax cost of debt is only about 4.7% after tax, which is what actually costs the company.
What does WACC tell me?
It is the blended minimum return the company must earn to satisfy both lenders and shareholders. It is used as the discount rate in DCF valuation and as a hurdle rate — a project should only clear if its expected return beats the WACC.
Why is the cost of equity higher than the cost of debt?
Shareholders are paid last and carry more risk, so they demand a higher return, and equity has no tax shield. Debt is contractually senior and tax-favored, so its cost is almost always lower — which is why leverage can pull WACC down, up to a point.
