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WACC

Weighted Average Cost of Capital.

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W A C C = \frac{E}{V} R_{e} + \frac{D}{V} R_{d} (1 - t)

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Core idea

Overview

The Weighted Average Cost of Capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. It reflects the minimum return a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital.

When to use: WACC is primarily used in discounted cash flow (DCF) analysis to value companies or to evaluate the feasibility of internal projects. It is most appropriate when the project being evaluated has a risk profile similar to the company's existing operations and follows the firm's target capital structure.

Why it matters: It serves as the 'hurdle rate' for business decisions; if a project cannot generate a return higher than the WACC, it will likely destroy shareholder value. For investors, WACC is a critical tool for determining the discount rate used to find the present value of future cash flows.

Symbols

Variables

WACC = WACC, E = Equity Value, D = Debt Value, R_e = Cost of Equity, R_d = Cost of Debt

W A C C

WACC

V a r iab l e

E

Equity Value

D

Debt Value

R_{e}

Cost of Equity

V a r iab l e

R_{d}

Cost of Debt

V a r iab l e

t

Tax Rate

V a r iab l e

Walkthrough

Derivation

Formula: Weighted Average Cost of Capital (WACC)

WACC is a firm’s average financing cost, weighting the cost of equity and after-tax cost of debt by their shares in total capital.

Capital structure proportions remain approximately stable.
Project risk is similar to the firm’s existing risk (so WACC is an appropriate hurdle rate).
Corporate tax rate T is applicable to interest tax relief (if assumed).

Weight the Cost of Equity:

Multiply the cost of equity $R_{e}$ by the equity proportion $E / V$ , where $V = E + D$ .

\frac{E}{V} R_{e}

Weight the After-Tax Cost of Debt:

Multiply the cost of debt $R_{d}$ by the debt proportion $D / V$ and by $(1 - T)$ to account for tax relief on interest (if applicable).

\frac{D}{V} R_{d} (1 - T)

Add to Get WACC:

Sum the weighted components to get the overall average cost of capital.

W A C C = \frac{E}{V} R_{e} + \frac{D}{V} R_{d} (1 - T)

Result

W A C C = \frac{E}{V} R_{e} + \frac{D}{V} R_{d} (1 - T)

Source: Standard curriculum — A-Level Finance

Free formulas

Rearrangements

Solve for $W A C C$

Make W the subject

W A C C = \frac{E R _{e} - D R _{d} t + D R _{d}}{V}

Exact symbolic rearrangement generated deterministically for W.

Difficulty: 3/5

Solve for $E$

Make E the subject

E = \frac{V W A C C + D R _{d} t - D R _{d}}{R _{e}}

Exact symbolic rearrangement generated deterministically for E.

Difficulty: 3/5

Solve for $D$

Make D the subject

D = \frac{- V W A C C + E R _{e}}{R _{d} ( t - 1 )}

Exact symbolic rearrangement generated deterministically for D.

Difficulty: 3/5

Solve for $R_{e}$

Make Re the subject

R_{e} = \frac{V W A C C + D R _{d} t - D R _{d}}{E}

Exact symbolic rearrangement generated deterministically for Re.

Difficulty: 3/5

Solve for $R_{d}$

Make Rd the subject

R_{d} = \frac{- V W A C C + E R _{e}}{D ( t - 1 )}

Exact symbolic rearrangement generated deterministically for Rd.

Difficulty: 3/5

Solve for $t$

Make t the subject

t = \frac{- V W A C C + E R _{e} + D R _{d}}{D R _{d}}

Exact symbolic rearrangement generated deterministically for t.

Difficulty: 3/5

The static page shows the finished rearrangements. The app keeps the full worked algebra walkthrough.

Visual intuition

Graph

The graph is a straight line because Re appears as a simple linear term with a constant coefficient of E/V. For a finance student, this means that as the cost of equity increases, the total cost of capital rises proportionally, reflecting how expensive it is for a firm to satisfy its shareholders. The most important feature is the positive slope, which demonstrates that any increase in the cost of equity directly pushes the total WACC higher, regardless of the debt components.

Graph type: linear

Why it behaves this way

Intuition

Visualize a company's total capital as a pie, divided into equity and debt slices. Each slice contributes to the overall cost based on its proportion and individual cost, with the debt slice's cost being reduced by a tax

WACC

The average rate of return a company expects to pay to all its capital providers (both debt and equity).

It's the minimum return a company must earn on its investments to satisfy its creditors and shareholders, often called the 'hurdle rate' for new projects.

The total market value of the company's outstanding shares (equity).

Represents the capital contributed by shareholders.

The total market value of the company's outstanding debt.

Represents the capital contributed by lenders.

The total market value of the company's financing, which is the sum of equity and debt (E + D).

Represents the entire capital structure of the firm.

R_{e}

The required rate of return for equity investors.

The compensation shareholders demand for the risk of investing in the company.

R_{d}

The required rate of return for debt holders (cost of debt).

The interest rate the company pays on its debt.

The corporate income tax rate.

Accounts for the tax savings a company gets from deducting interest expenses.

Signs and relationships

(1-t): This term reduces the cost of debt because interest payments are tax-deductible. The company effectively pays $R_{d}$ but gets t * $R_{d}$ back as a tax shield, making the net cost $R_{d}$ * (1-t).

Free study cues

Insight

Canonical usage

Monetary values for equity and debt are used to calculate dimensionless weights, which are then multiplied by cost rates (expressed as decimals)

Common confusion

The primary confusion arises from incorrectly using percentages directly in calculations instead of converting them to decimals. For example, using '10' for 10% instead of '0.10'.

Dimension note

The ratios E/V and D/V are dimensionless weights. The rates $R_{e}$ , $R_{d}$ , and t are also dimensionless proportions, typically expressed as percentages.

Unit systems

$W A C C$ % · Represents an annual rate of return or discount rate. Typically expressed as a percentage but used as a decimal in calculations.

$E$ currency (e.g., USD, EUR) · Market value of equity. Must be in consistent currency units with D and V.

$D$ currency (e.g., USD, EUR) · Market value of debt. Must be in consistent currency units with E and V.

$V$ currency (e.g., USD, EUR) · Total market value of the firm (V = E + D). Must be in consistent currency units.

$R_{e}$ % · Cost of equity, typically an annual rate. Must be converted to decimal form for calculation.

$R_{d}$ % · Cost of debt, typically an annual rate. Must be converted to decimal form for calculation.

$t$ % · Corporate tax rate. Must be converted to decimal form for calculation.

Ballpark figures

Quantity:

One free problem

Practice Problem

A corporation has a market value of equity of 600,000 and a market value of debt of 400,000. If the cost of equity is 12%, the pre-tax cost of debt is 6%, and the corporate tax rate is 25%, calculate the WACC.

Equity Value600000 $

Debt Value400000 $

Cost of Equity0.12

Cost of Debt0.06

Tax Rate0.25

Solve for: $W$

Hint: Calculate the total value V = E + D first, then apply the weights to the costs of capital.

The full worked solution stays in the interactive walkthrough.

Where it shows up

Real-World Context

Determining the minimum return a new factory must generate.

Study smarter

Tips

Always use the market value of debt and equity rather than book values from the balance sheet.
The (1-t) term accounts for the tax shield, as interest payments on debt are usually tax-deductible.
V is the total market value of the firm, which equals the sum of Equity (E) and Debt (D).

Avoid these traps

Common Mistakes

Forgetting (1-t) for debt.
Using book values instead of market values.

Common questions

Frequently Asked Questions

WACC is a firm’s average financing cost, weighting the cost of equity and after-tax cost of debt by their shares in total capital.

WACC is primarily used in discounted cash flow (DCF) analysis to value companies or to evaluate the feasibility of internal projects. It is most appropriate when the project being evaluated has a risk profile similar to the company's existing operations and follows the firm's target capital structure.

It serves as the 'hurdle rate' for business decisions; if a project cannot generate a return higher than the WACC, it will likely destroy shareholder value. For investors, WACC is a critical tool for determining the discount rate used to find the present value of future cash flows.

Forgetting (1-t) for debt. Using book values instead of market values.

Determining the minimum return a new factory must generate.

Always use the market value of debt and equity rather than book values from the balance sheet. The (1-t) term accounts for the tax shield, as interest payments on debt are usually tax-deductible. V is the total market value of the firm, which equals the sum of Equity (E) and Debt (D).

References

Sources

Principles of Corporate Finance by Richard A. Brealey, Stewart C. Myers, Franklin Allen
Corporate Finance by Stephen A. Ross, Randolph W. Westerfield, Jeffrey F. Jaffe
Wikipedia: Weighted average cost of capital
Brealey, Myers, and Allen, Principles of Corporate Finance
Ross, Westerfield, and Jaffe, Corporate Finance
Brealey, Richard A., Myers, Stewart C., Allen, Franklin. Principles of Corporate Finance. McGraw-Hill Education.
Berk, Jonathan, DeMarzo, Peter, Harford, Jarrad. Corporate Finance. Pearson.
Standard curriculum — A-Level Finance

WACC

Overview

Variables

Derivation

Weight the Cost of Equity:

Weight the After-Tax Cost of Debt:

Add to Get WACC:

Rearrangements

Graph

Intuition

Insight

Practice Problem

Real-World Context

Tips

Common Mistakes

Related Formulas

Gearing Ratio

CAPM (Expected Return)

Frequently Asked Questions

Sources