Weighted Average Cost of Capital (WACC)

Companies fund themselves with a mix of debt and equity, and each has a different cost. WACC combines them into one figure by weighting each cost by its share of total funding. Because interest is usually tax-deductible, the cost of debt is used after tax.

Suppose a company is funded 60% by equity and 40% by debt. Shareholders require 10%, lenders charge 6% and the tax rate is 25%, so the after-tax cost of debt is 4.5%. The WACC is 60% of 10% plus 40% of 4.5%, which is 6% plus 1.8%, giving 7.8%.

WACC is widely used as the discount rate when valuing a company's future cash flows and as the hurdle rate for new investments. A project expected to earn more than the WACC should create value; one that earns less should not.

WACC rests on estimates, especially the cost of equity, which cannot be observed directly. Small changes in assumptions can change it noticeably, which in turn can make large differences in valuations.