If you’ve ever built or reviewed a DCF model, you’ve come across WACC—the Weighted Average Cost of Capital. It shows up in the denominator of every discounted cash flow calculation. But what exactly does it represent? And why does it have such a big impact on valuation?
WACC is a financial translation of investor expectations. It tells you how much return a company must generate to fairly compensate both equity holders and lenders for the risks they’re taking. In simple terms:
WACC is the average rate a company is expected to pay to finance its operations.
In this article, we’ll break down what WACC is, how it’s calculated, where the inputs come from, and why even small changes in WACC can cause large swings in valuation.
What WACC Actually Represents
WACC reflects the blended cost of a company’s financing. Most companies don’t fund themselves with 100% equity or 100% debt. They use a mix—typically a combination of shareholder capital (equity) and borrowed money (debt). WACC combines the cost of each, weighted by their proportion in the company’s capital structure.
Think of it this way:
If a company is 60% funded by equity and 40% by debt, WACC calculates the average rate of return required by those two groups—based on the risk they’re taking.
Here’s the core formula:
WACC = (E / (E + D)) × Re + (D / (E + D)) × Rd × (1 – Tc)
Where:
- E = market value of equity
- D = market value of debt
- Re = cost of equity
- Rd = cost of debt
- Tc = corporate tax rate
We’ll break each of these down in the next section.
Breaking Down the Components of WACC
To understand WACC properly, you need to know what goes into it—and where those numbers come from. Let’s walk through each part of the formula:
1. Market Value of Equity (E)
This is the company’s market capitalization—the total value of all its shares at the current stock price.
Equity (E) = Share Price × Number of Shares Outstanding
For private companies, estimating this can be tricky. Analysts often use recent funding rounds, comparable company multiples, or valuation models to approximate the equity value.
2. Market Value of Debt (D)
This includes all interest-bearing debt, such as bonds, term loans, and credit facilities. Ideally, it should reflect market value, but in practice, the book value from the balance sheet is often used—unless the debt trades at a discount or premium.
3. Cost of Equity (Re)
This is the return that equity investors expect, based on the risk of holding the company’s stock. The most common way to estimate it is using the Capital Asset Pricing Model (CAPM):
Re = Risk-Free Rate + Beta × Market Risk Premium
- The risk-free rate is usually the yield on a long-term government bond (like the 10-year U.S. Treasury).
- Beta measures how volatile the company’s stock is relative to the market.
- The market risk premium reflects how much return investors demand above the risk-free rate to invest in equities.
4. Cost of Debt (Rd)
This is the interest rate the company pays on its borrowings, adjusted for the tax shield (because interest is tax-deductible). If the company has multiple loans or bonds, you can calculate a weighted average interest rate based on the outstanding amounts and interest terms.
5. Corporate Tax Rate (Tc)
Because debt interest is tax-deductible, the effective cost of debt is lower than the headline interest rate. The tax shield is factored in using:
After-Tax Cost of Debt = Rd × (1 – Tc)
If the company is in a low-tax jurisdiction or has tax losses, this shield might be minimal.
Once all these components are in place, you can plug them into the WACC formula and calculate the company’s blended cost of capital—which becomes the discount rate in a DCF model.
Why WACC Has Such a Big Impact on Valuation
WACC plays a powerful role in valuation. It’s the rate at which future cash flows are discounted back to present value. The higher the WACC, the lower the present value of those future cash flows—and therefore, the lower the company’s valuation.
This is because WACC captures both risk and required return. A company with stable cash flows, low leverage, and operations in a developed country may have a WACC of 7–8%. But a fast-growing, debt-heavy business in an emerging market might have a WACC of 12–15% or more. That difference can drastically reduce the DCF valuation—even if the cash flows are similar.
Let’s say you expect $100 million in cash flow 5 years from now:
- At an 8% WACC, its present value is about $68 million
- At a 12% WACC, it drops to $57 million
- At a 15% WACC, it falls further to $50 million
And that’s just one year of cash flow. Over a full forecast period plus terminal value, the difference compounds dramatically.
The takeaway:
WACC reflects how the market prices risk—and it directly affects how much a business is worth.
Closing Thoughts
WACC is more than a formula—it’s the bridge between a company’s expected cash flows and the return required by those who finance it. It brings together the perspectives of equity investors and lenders, filters them through risk and capital structure, and turns that into a single number: the rate you use to value the business.
Understanding WACC means understanding how capital markets view the company. It’s affected by business fundamentals, macroeconomic conditions, country risk, tax policy, and investor sentiment. And in valuation, even small shifts in WACC can swing outcomes dramatically.
Good practitioners don’t just plug in a number—they build it carefully, challenge their assumptions, and understand how it fits the story. Because if WACC is wrong, the valuation falls apart—no matter how good the model looks.