What it means
Every business is funded by lenders, who expect interest, and by owners, who expect a return on their investment. WACC combines those two expectations into one percentage so managers can judge whether a project creates value.
Debt is usually cheaper than equity because lenders are paid first and take less risk. Interest is also normally tax-deductible, so the cost of debt used in WACC is reduced by the tax rate to reflect the saving.
Equity has no stated price tag, so the cost of equity has to be estimated. A common method is the capital asset pricing model, which adds a risk premium (the extra return investors want for taking market risk) to a risk-free rate.
WACC is the standard discount rate for valuing a business with discounted cash flow analysis. It is also the hurdle rate for investment decisions, meaning a project expected to earn less than WACC destroys value, while one that earns more adds to it.
The weights should use market values of debt and equity rather than book values where possible. WACC also moves as interest rates, the share price and the capital structure change, so it should be reviewed rather than set once and forgotten.
Small differences in WACC can change decisions a great deal. A project that looks comfortably profitable at 8% may become marginal at 10%, which is why finance teams often test several rates, and why valuers often present a range rather than a single answer.
In practice
Real-world examples.
Example
A manufacturer considers a new production line expected to return 11% a year. The company WACC is 9%, so the project clears the hurdle by two percentage points and goes ahead for board approval. The team still tests the result at a WACC of 11% to see whether it survives a harsher assumption.
Example
A private equity analyst values a software business by discounting its forecast cash flows at a WACC of 10%. Raising the rate to 11% reduces the valuation noticeably, so she shows the board a range rather than a single figure. The range makes clear that the valuation depends heavily on one assumption.
Example
A retail chain borrows heavily to fund new stores, which raises the share of cheaper debt in its mix. Its WACC falls at first, but lenders and shareholders then demand higher returns because the business has become riskier, and the benefit shrinks. Its treasurer learns that adding cheap debt does not lower the cost of capital indefinitely.
Formula
Calculation
WACC = (E / V x Re) + (D / V x Rd x (1 - T))
where E is the market value of equity, D is the market value of debt, V = E + D, Re is the cost of equity, Rd is the cost of debt and T is the tax rate.
Suppose a company has equity of $6,000,000 and debt of $4,000,000, so V = $10,000,000. The cost of equity is 12%, the cost of debt is 6% and the tax rate is 25%. The equity part is 6,000,000 / 10,000,000 x 12% = 0.6 x 12% = 7.2%. The debt part is 0.4 x 0.06 x 0.75 = 0.018, which is 1.8%. WACC = 7.2% + 1.8% = 9.0%, so projects should be expected to return more than 9.0%. If the cost of equity were 14% instead, the equity part would rise to 0.6 x 14% = 8.4% and WACC would become 8.4% + 1.8% = 10.2%, showing how sensitive the answer is to the equity estimate.Case study
Seen in the real world.
Lakeside Logistics is an illustrative, fictional haulage business weighing a $3,000,000 investment in refrigerated trucks. The project is expected to return 8.5% a year, and the sales team argued that this beat the 6% interest rate on the loan being offered.
The finance manager pointed out that the right comparison was the company-wide WACC of 9.2%, because the loan and the owners' capital together fund the business. Against that yardstick the project fell short.
After the team renegotiated contracts to lift the expected return to 10.5%, the project cleared the hurdle and was approved. The illustrative lesson is that a cheap loan does not make a project worthwhile on its own. Lakeside now requires every investment paper to quote the project return next to the company WACC, not next to the interest rate on the loan.
Watch out
Common mistakes.
- Comparing a project's return with the interest rate on the loan used to fund it, rather than with the blended WACC.
- Forgetting to adjust the cost of debt for tax, which overstates WACC.
- Using the same WACC for every project even when a project carries clearly higher or lower risk than the company as a whole.
Questions
People also ask.
Why is the cost of equity higher than the cost of debt?
Shareholders are paid after lenders and carry more risk, so they expect a higher return as compensation.
Should I use book values or market values for the weights?
Market values are preferred because they reflect what investors would require today, although book values are sometimes used when market data is not available.
Can WACC be negative?
In practice no, because both debt and equity carry a positive cost, although the cost of debt can be very low. If interest rates fall to near zero, WACC falls too, but the equity part usually keeps it clearly positive.
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