# Understanding WACC: Definition, Formula, and Calculation Explained

Both investors and companies can use this key metric

## What Is Weighted Average Cost of Capital (WACC)?

Weighted average cost of [capital](https://www.investopedia.com/terms/c/capital.asp) (WACC) is a vital metric for assessing a company's financing costs by averaging the after-tax [cost of all capital](https://www.investopedia.com/terms/c/costofcapital.asp) sources like equity and debt. Investors use WACC to determine the [required rate of return (RRR)](https://www.investopedia.com/terms/r/requiredrateofreturn.asp), and companies rely on it to evaluate potential projects and acquisitions. A higher WACC indicates riskier investments, demanding greater returns. This article unpacks WACC's calculation, its role in corporate finance, and its significance in investment decisions.

### Key Takeaways

*   Weighted Average Cost of Capital (WACC) is a critical financial metric that combines the cost of equity and debt, reflecting the average rate a company must pay to finance its business.
*   WACC is widely used by investors and company management as it serves both as a discount rate in cash flow analysis and as a benchmark for evaluating investment opportunities.
*   Calculating WACC involves determining the market value proportions of debt and equity financing, and it accounts for tax advantages associated with interest expenses.
*   While WACC provides valuable insights into a company's financial health, its calculation can be complex due to varying assumptions and requires careful consideration of market conditions and inputs.

![Weighted Average Cost of Capital (WACC)](https://www.investopedia.com/thmb/P8oFGFnEhktVM1kE0UZvQ0qzj2Y=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/TermDefinitions_wacc_final-626b8af9bfc741d6a9792fe0568242cd.png)

*— Jessica Olah / Investopedia*

## Demystifying WACC

Calculating a company's WACC helps investors, stock analysts, and company managers. Each group uses it differently.

In corporate finance, determining a company's cost of capital can be important for several reasons. For example, WACC can serve as the [discount rate](https://www.investopedia.com/terms/d/discountrate.asp) when estimating a project's or acquisition's [net present value](https://www.investopedia.com/terms/n/npv.asp).

If the company believes that a merger, for example, will generate a return higher than its cost of capital, then it's likely a good choice for the company. However, if it anticipates a return lower than its investors are expecting, there might be better uses for that capital.

To investors, WACC is an important tool in assessing a company's potential for profitability. Generally, a lower WACC suggests a healthy business that can attract investors more cheaply. A higher WACC often indicates riskier businesses that must offer higher returns to attract investors.

If a company only obtains financing through one source—say, common stock—then calculating its cost of capital would be relatively simple. If investors expected a [rate of return (RoR)](https://www.investopedia.com/terms/r/rateofreturn.asp) of 10% on their [shares](https://www.investopedia.com/terms/s/shares.asp), the company's cost of capital would be the same as its cost of equity: 10%. 

The same would be true if the company only used debt financing. For example, if the company paid an average yield of 5% on its bonds, its pre-tax cost of debt would be 5%. But interest payments are tax-deductible, so the after-tax cost of debt would be lower, at 5% × (1 - tax rate). This after-tax cost of debt would also represent the company's cost of capital in this scenario, since all the capital is debt.

However, many companies use both debt and equity financing in various proportions. This is where the calculation for WACC becomes valuable.

## Calculating WACC: Formula Breakdown

WACC is found by determining the proportions of debt and equity financing that a company uses to determine the total cost of capital. The equation is:  

$\begin{aligned} &\text{WACC} = \left ( \frac{ E }{ V} \times Re \right ) + \left ( \frac{ D }{ V} \times Rd \times ( 1 - Tc ) \right ) \\ &\textbf{where:} \\ &E = \text{Market value of the firm's equity} \\ &D = \text{Market value of the firm's debt} \\ &V = E + D \\ &Re = \text{Cost of equity} \\ &Rd = \text{Cost of debt} \\ &Tc = \text{Corporate tax rate} \\ \end{aligned}$

WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight and then adding those results together. In the formula, E/V shows the proportion of equity financing, and D/V represents the proportion of debt financing. The WACC formula thus involves the summation of two terms:

$\left ( \frac{ E }{ V} \times Re \right )$

$\left ( \frac{ D }{ V} \times Rd \times ( 1 - Tc ) \right )$

The former represents the weighted value of equity capital, while the latter represents the weighted value of debt capital.

Suppose that a company obtained $1 million in debt financing and $4 million in equity financing by selling common shares. The total capital would be $5 million (debt plus equity), so tose proportions would be:

> E/V = $4,000,000 / $5,000,000 = 0.8

> D/V = $1,000,000 / $5,000,000 = 0.2

You can double check that the proportions are correct because 0.8 + 0.2 = 1.0.

> **Tip**
>
> WACC can be calculated using Excel.

## Important Factors in WACC Calculation

### Calculating Cost of Equity

[Cost of equity](https://www.investopedia.com/terms/c/costofequity.asp) (Re in the formula) can be a bit tricky to calculate because share capital does not technically have an explicit value. When companies reimburse bondholders, the amount they pay has a predetermined [interest rate](https://www.investopedia.com/terms/i/interestrate.asp). On the other hand, equity has no concrete price that the company must pay. As a result, companies have to estimate the cost of equity (the rate of return that investors demand based on the expected [volatility](https://www.investopedia.com/terms/v/volatility.asp) of the stock).

Because shareholders will expect to receive a certain [return on their investment](https://www.investopedia.com/terms/r/returnoninvestment.asp) in a company, the equity holders' required rate of return is a cost from the company's perspective; if the company fails to deliver this expected return, shareholders may simply sell their shares, which can lead to a decrease in both share price and the company's value.

> **Important**
>
> The cost of equity is the total return that a company must generate to maintain a share price that will satisfy its investors.

Companies typically use the [capital asset pricing model (CAPM)](https://www.investopedia.com/terms/c/capm.asp) to arrive at the cost of equity (in CAPM, it's called the expected return of investment). It’s important to note this calculation relies on past data, which can't precisely predict future growth.

### Calculating Cost of Debt

Determining [cost of debt](https://www.investopedia.com/terms/c/costofdebt.asp) (Rd in the formula), on the other hand, is a more straightforward process. This is often done by averaging the [yield to maturity](https://www.investopedia.com/terms/y/yieldtomaturity.asp) for a company's outstanding debts. This method is easier if you're looking at a publicly traded company that has to report its debt obligations.

For privately owned companies, you can look at the company's [credit rating](https://www.investopedia.com/terms/c/corporate-credit-rating.asp) from firms such as Moody's and S&P Global and then add a relevant spread over risk-free assets to approximate the return that investors would demand.

> **Tip**
>
> Treasury bonds of the same maturity are a useful risk-free asset to use as a benchmark.

Businesses are able to deduct interest expenses from their taxes. Because of this, the net cost of a company's debt is the amount of [interest](https://www.investopedia.com/terms/i/interest.asp) it is paying minus the amount of interest it can deduct on its taxes. This is why Rd x (1 - the corporate tax rate) is used to calculate the after-tax cost of debt.

## Comparing WACC and Required Rate of Return (RRR)

The required rate of return is the minimum return that an investor will accept in exchange for their investment. If returns are expected to be lower, investors will choose other investments.

One way to determine the RRR is by using the capital asset pricing model, which looks at a stock's volatility relative to the broader market (known as its [beta](https://www.investopedia.com/terms/b/beta.asp)). This is then used to estimate the return that stockholders will require.

Calculating WACC is another way to find the RRR. WACC's advantage is that it considers the company's capital structure, balancing debt and equity. This can give a more accurate picture of investors' expectations.

## Limitations and Challenges of WACC

Like any metric used to assess the financial strength of a business, there are limitations to using the weighted average cost of capital.

The biggest limitation is in calculating WACC: the formula can appear easier to calculate than it is. There are a few different reasons for this:

*   **Inconsistent numbers**: Certain elements of the formula, such as the cost of equity, are not consistent values. As a result, different parties may report different numbers.
*   **Complex structures**: Calculating WACC can be tough for companies with complex balance sheets and multiple debt types and interest rates.
*   **Number of inputs**: There are many [inputs to calculating WACC](https://www.investopedia.com/ask/answers/070114/how-do-interest-rates-affect-weighted-average-cost-capital-wacc-calculation.asp), such as interest rates and tax rates, all of which can be affected by market and economic conditions.

The best way to use WACC is in combination with other financial metrics. When deciding to invest, always aim to get a full picture of a company's financial health and growth potential.  

## Practical Example: Calculating WACC

Consider a hypothetical manufacturer called XYZ Brands. Suppose the [market value](https://www.investopedia.com/terms/m/marketvalue.asp) of the company's debt is $1 million, and its [market capitalization](https://www.investopedia.com/terms/m/marketcapitalization.asp) (or the market value of its equity) is $4 million. 

Let's further assume that XYZ's cost of equity—the minimum return that shareholders demand—is 10%. Here, E/V would equal 0.8 ($4,000,000 of equity value divided by $5,000,000 of total financing). Therefore:

> Weighted cost of equity = 0.8 × 0.10 = 0.08

This is the first half of the WACC equation.

Now we have to figure out XYZ's weighted cost of debt. To do this, we need to determine D/V; in this case, that's 0.2 ($1,000,000 in debt divided by $5,000,000 in total capital). Next, we would multiply that figure by the company's cost of debt, which we'll say is 5%. Last, we multiply the product of those two numbers by 1 minus the tax rate. If the tax rate (Tc) is 0.25, then "1 minus Tc" is equal to 0.75. Therefore:

> Weighted cost of debt = (0.2 × 0.05) x 0.75 = 0.0075

Adding those two numbers together gives the weighted average cost of capital:

> WACC = 0.08 + 0.0075 = 0.0875 = 8.75%

This value represents XYZ's average cost to attract investors and the return that they're going to expect, given the company's financial strength and risk compared with other investment opportunities. 

## What Is a Good Weighted Average Cost of Capital (WACC)?

What represents a ["good" weighted average cost of capital](https://www.investopedia.com/ask/answers/013015/what-does-high-weighted-average-cost-capital-wacc-signify.asp) will vary from company to company, depending on a variety of factors (whether it is an established business or a startup, its capital structure, the industry in which it operates, etc). One way to judge a company's WACC is to compare it to the average for its industry or sector. For example, according to Kroll research, the average WACC for companies in the consumer staples sector was 7.9% in March 2024, while it was 11.3% in the information technology sector.

## What Is Capital Structure?

Companies use various means to obtain the capital they need, which can include issuing bonds (debt) and shares of stock (equity). [Capital structure](https://www.investopedia.com/terms/c/capitalstructure.asp) refers to how they mix the two.

## What Is a Debt-to-Equity Ratio?

A [debt-to-equity ratio](https://www.investopedia.com/terms/d/debtequityratio.asp) is another way of looking at the risk that investing in a particular company may hold. It compares a company's liabilities to the value of its shareholder equity. The higher the debt-to-equity ratio, the riskier a company is often considered to be.

## The Bottom Line

Weighted average cost of capital (WACC) represents the average rate a company expects to pay its capital providers, reflecting the proportional cost of its debt and equity financing. Both investors and company executives utilize WACC to assess the risk and potential reward of investments, projects, or business ventures. While crucial, WACC's calculation is complex and should not stand alone in financial analysis. To make informed financial decisions, incorporate WACC alongside other financial metrics for a comprehensive evaluation of a company's economic health and investment potential.

> **Article Sources**
>
> 1.  Harvard Business School Online. "[Cost of Capital: What It Is & How to Calculate It](https://online.hbs.edu/blog/post/cost-of-capital)."
>     
> 2.  Internal Revenue Service. "[Topic No. 505 Interest Expense](https://www.irs.gov/taxtopics/tc505)."
>     
> 3.  Nasdaq. "[Required Rate of Return (RRR)](https://www.nasdaq.com/glossary/r/required-rate-of-return)."
>     
> 4.  Kroll. "[U.S. Industry Benchmarking Module](https://www.kroll.com/en/cost-of-capital/us-industry-benchmarking)."
>     
> 5.  Harvard Business Review. "[A Refresher on Debt-to-Equity Ratio](https://hbr.org/2015/07/a-refresher-on-debt-to-equity-ratio)."