What WACC means
WACC (weighted average cost of capital) is the blended required return of capital providers: equity holders and debt holders. Debt is adjusted for taxes because interest is often tax deductible.
Core formula
WACC = w_e*k_e + w_d*k_d*(1 - tax rate)
How to calculate WACC (step-by-step)
- Estimate market-value weights for equity and debt (w_e and w_d).
- Estimate cost of equity (k_e), often via CAPM as a starting point.
- Estimate cost of debt (k_d) from current borrowing rates or comparable issuers.
- Apply the tax shield: after-tax cost of debt = k_d * (1 - tax rate).
- Compute WACC using the core formula above.
How to choose inputs (practical)
- Weights: use market-value capital structure when possible (not book values).
- Cost of equity: often estimated via CAPM as a starting point (risk-free + beta*equity risk premium).
- Cost of debt: current borrowing rate for the firm's risk profile.
- Tax rate: marginal corporate tax rate applicable to interest deductions.
Common mistakes
- Using WACC for projects with different risk than the business.
- Using a single-point WACC without sensitivity analysis.
- Letting terminal value dominate because discount rate is too low.