What it means
A business funds itself with a mix of borrowed money and shareholder money, and each has a price. Debt has an obvious price, the interest rate, while equity has a hidden one: the return shareholders expect for taking the risk of owning the business.
This measure puts the two together in proportion to how much of each sits in the capital structure. Interest on debt is tax deductible in most jurisdictions, so the true cost to the company is the interest rate after tax relief.
That is why the debt side of the formula is multiplied by one minus the tax rate. Equity gets no such relief, which is part of why debt looks cheaper than it really is until you account for the extra risk it adds.
It matters because it is the number a project has to beat. If a proposed investment is expected to return 11% and the company's cost of capital is 9%, the project adds value; at 7% it destroys value even though it is technically profitable.
It is also the discount rate used in discounted cash flow valuations, so small changes move valuations a great deal. Cost of equity is the hardest input and is usually estimated with the capital asset pricing model, which builds it up from a risk-free rate, the market's average extra return and a measure of how volatile the company is relative to the market.
Cost of debt comes from the actual interest rate on borrowings, and the weights should ideally use market values rather than the figures sitting in the accounts. Many companies simply set a corporate hurdle rate a few points above the calculated figure and use that instead.
The nuance worth knowing is that one company-wide rate can mislead. A stable core business and a speculative new venture do not carry the same risk, so applying a single discount rate to both quietly subsidises the risky project at the expense of the safe one.
Larger groups often set divisional rates to correct for this.
In practice
Real-world examples.
Example
A utility with heavy regulated assets calculates a cost of capital of 6.5% because its cash flows are predictable and it can borrow cheaply. A biotechnology firm in the same country calculates 14%, since its shareholders demand far more for the risk, and the two companies would value an identical cash flow stream very differently as a result.
Example
A finance team valuing an acquisition target discounts five years of projected cash flows plus a terminal value at the acquirer's 9% cost of capital. Raising the rate to 10% cuts the calculated value by roughly a tenth, which is why the negotiating team stress-tests the discount rate before committing to a price.
Example
A group treasurer refinances $20,000,000 of equity-funded operations with cheaper debt and watches the calculated cost of capital fall. The board notes that the fall is partly an illusion, since more debt raises financial risk and will eventually push up the return shareholders demand.
Think of it
“WACC is like the blended interest rate you pay across all your debts-some cheap like a mortgage, some expensive like credit cards-averaged by size.
Formula
Calculation
WACC = (E / V x Re) + (D / V x Rd x (1 - t))
E is the market value of equity, D is the market value of debt, V is E + D, Re is the cost of equity, Rd is the pre-tax cost of debt, and t is the corporate tax rate.
A manufacturer is funded by $60,000,000 of equity and $40,000,000 of debt, so total capital V = $100,000,000. Shareholders require 12%, the loans carry 6% interest, and the tax rate is 25%.
Equity weight = $60,000,000 / $100,000,000 = 60%, contributing 0.60 x 12% = 7.2%
Debt weight = $40,000,000 / $100,000,000 = 40%, and the after-tax cost of debt is 6% x (1 - 0.25) = 4.5%, contributing 0.40 x 4.5% = 1.8%
WACC = 7.2% + 1.8% = 9.0%
Any project this company backs must return more than 9% a year to leave shareholders better off. A new production line promising 8% would be rejected, even though it produces a positive accounting profit, because the capital funding it costs more than the line earns.Case study
Seen in the real world.
This is an illustrative, fictional case. Bramwell Industrial, an invented components group, approved capital projects using a rule of thumb: anything returning more than 6% went ahead, because 6% was what the bank charged. Over four years the group invested $30,000,000 in projects averaging a 7.5% return and could not understand why the share price went nowhere.
A new chief financial officer calculated the real cost of capital. With equity at 70% of funding and shareholders expecting 13%, plus debt at 30% costing 6% before tax and 4.5% after, the weighted figure came to 0.70 x 13% + 0.30 x 4.5% = 9.1% + 1.35% = 10.45%. Every project approved on the 6% test had been destroying value.
Bramwell reset its hurdle rate to 11% and rejected two of the three projects then in the pipeline. Capital spending halved, cash returned to shareholders rose, and the remaining projects were genuinely worth doing. The illustrative point is that using the interest rate alone as a hurdle ignores the far larger and more expensive pool of shareholder money.
Watch out
Common mistakes.
- Treating equity as free because it carries no interest payment. Shareholders expect a return for the risk they take, and that expectation is normally the most expensive part of the capital structure.
- Using book values from the balance sheet as the weights. Market values reflect what the debt and equity are actually worth today, and using stale book figures can distort the result badly.
- Applying one group-wide rate to every project regardless of risk. A single rate makes risky ventures look better than they are and makes safe, steady investments look worse.
Questions
People also ask.
Does more debt always lower the cost of capital?
Only up to a point, because beyond a sensible level of gearing both lenders and shareholders demand higher returns for the added risk of financial distress.
Should the rate be updated every year?
Reviewing it annually is normal practice, since interest rates, tax rates and the company's mix of debt and equity all shift over time.
What is the difference between the cost of capital and a hurdle rate?
The cost of capital is the calculated break-even return, while the hurdle rate is the higher bar management actually sets to allow for forecasting optimism and execution risk.
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