Ultimate Guide to Weighted Average Cost of Capital (WACC)

Think of WACC as your company’s “hurdle rate”. The minimum return you must earn to keep everyone happy. If your lenders want 10% and shareholders expect 20%, your blended cost (WACC) might be around 15%. This means every dollar you invest in a new project must earn at least 15%, or you are technically losing money.

For founders and investors, a lower WACC is better because it means cheaper capital and a higher company valuation. It’s not just a theoretical number; boards use it to set performance targets, and investors use it to decide if your business is creating real value or just spinning its wheels.

Key Takeaways

• WACC represents the average rate a company expects to pay to finance its assets through debt and equity capital.
• The WACC formula is: WACC = (E/V * Re) + (D/V * Rd * (1-T))
• A higher WACC indicates a riskier company with higher financing costs, while a lower WACC suggests lower risk and cheaper financing costs.
• WACC is used as the discount rate to evaluate new investment projects. Projects with returns above the WACC are considered value-creating.

What is Weighted Average Cost of Capital (WACC)?

WACC is a method of calculating a company’s cost of capital in which each capital type is proportionately weighted. A WACC computation considers all sources of capital, including common stock, preferred stock, bonds, and any other forms of debt. Company management uses WACC in determining where it’s worth going through a project, while investors use WACC to determine whether an investment is worthwhile.

How to Calculate WACC: The Formula & Components

Calculating WACC is essentially figuring out the “blended price” of the money you use to run your business. Since most companies use a mix of their own cash (Equity) and borrowed cash (Debt), we need to weigh them based on how much of each you use.

It looks complex, but it breaks down into two simple buckets: The Cost of Equity and The After-Tax Cost of Debt.

Here is exactly what every symbol means and where to find the data:

What is a good WACC?

A good WACC depends on balancing debt and equity costs, for instance, if debtholders demand a 10% return and shareholders require 20%, projects must average 15% returns to satisfy both, with the optimal capital structure minimizing WACC (thus maximizing firm value) by finding the ideal debt-to-equity ratio that lowers the overall cost of capital and boosts the present value of future cash flows.

Calculating WACC assesses the relative costs of equity, debt, and preferred stock, using either market or book values, and serves as a key internal benchmark for the cost of capital.

In incentive compensation, it validates performance metrics such as return on invested capital, capital employed, assets, or equity, allowing compensation committees to confirm whether targets meet or exceed the company’s WACC over the period, ensuring fairness.

Uses of Weighted Average Cost of Capital

When you get your company’s WACC, there are several instances where you can use it. The WACC can be used by the company and the investors in making decisions regarding any investments or projects.

• WACC can be used to assess investment opportunities as it represents a company’s opportunity cost. For example, securities analysts make use of WACC when valuing and selecting investments.
• Companies can use the WACC to evaluate new projects that have a similar risk level or have the same risk level of existing projects. For example, an automobile manufacturer wants to expand its business in new locations (i.e. setting up another factory in a new location). The company can use the WACC as a hurdle rate to decide whether they should enter into the project or not.
• When considering mergers and acquisitions (M&A), as well as financial modeling of internal investments, a company’s WACC is sometimes used as a hurdle rate. Instead of investing in a project, if an investment opportunity has a lower Internal Rate of Return (IRR) than its WACC, it should buy back its own shares or issue a dividend.

Example: Calculating WACC Step-by-Step

Let’s calculate WACC for a mid-sized manufacturing company called ABC Manufacturing Ltd.

What This WACC Means

ABC Manufacturing must earn at least 11.76% return on its investments to satisfy both shareholders and lenders.

Practical Applications:

• Project evaluation: Any new project (like buying machinery or expanding factory) must generate returns above 11.76% to be accepted
• Company valuation: If someone wants to buy ABC Manufacturing, they’ll discount future cash flows at 11.76% to find the fair value
• Performance benchmark: If ABC’s actual return is 14%, they’re creating value. If it’s 9%, they’re destroying value.

Nominal vs Real WACC

Nominal WACC is the discount rate you use when your forecasted cash flows are in future money (they include inflation). Real WACC is the discount rate you use when your cash flows are in today’s money (inflation removed).

Simple rule: if your cash flows grow because prices rise (inflation), use nominal WACC.  If you keep numbers in today’s prices (no inflation), use real WACC just don’t mix the two.

Pros and Cons of Weighted Average Cost of Capital

For all finance professionals, it’s important to have a good understanding of what WACC is, especially its advantages and disadvantages.

Pros

Here are the advantages of getting the WACC of your company:

• Used as a Measure for Inter-Firm Comparison – Compared to other companies in the same industry, a company with a lower WACC is better positioned. It has the potential to add additional value to its stakeholders.
• Used for Valuing a Firm – A valuation team uses WACC to calculate the firm’s value. The cash available to all debt and equity holders is free cash flow to firms (FCFF).
• Used as a Hurdle Rate – To satisfy your company’s shareholders and creditors, it’s important to determine the WACC as it’s the minimum rate of return your company must generate. As a result, WACC serves as a hurdle rate that firms must overcome to generate value for all shareholders and stakeholders.
• A Criterion to Accept or Reject a New Project – The corporate finance team uses the weighted average cost of capital to decide whether to approve or reject a project. To decide whether to accept or reject a project, the IRR (Internal Rate of Return) is compared to the firm’s cost of capital.

Cons

Below are some of the disadvantages of the WACC:

• Cost of Equity is Difficult to Calculate – Before computing for the WACC, the cost of debt and cost of equity must be estimated first. The cost of equity calculation for public companies has various methods and determining which method to use must be well thought out. There is no single formula to calculate the cost of equity.
• Unrealistic Assumptions: “D/E Mix will Remain Constant” – The debt-to-equity ratio will fluctuate, and the WACC will fluctuate as well. WACC is supposed to be constant for the firm’s entire value, which means that the debt/equity ratio will be constant, which is impossible.
• Increasing Debt to Achieve Lower WACC is Problematic – By putting debt on the balance sheet, WACC can be reduced. In pursuing a lower WACC, adding debt beyond the optimal capital structure might increase the present value of the cost of financial distress more than the value of the levered firm.

Why Does WACC Assume Your Capital Structure Stays the Same?

When you calculate your WACC, there’s a hidden assumption – The mix of debt (loans) and equity (shares) in your company will stay roughly the same forever.

Why does this matter?

• Debt is Cheaper: Taking a loan is almost always cheaper than selling equity because interest payments are tax-deductible. If you suddenly borrow a lot, your WACC drops. If you pay off debt, your WACC goes up.
• Stability for Planning: As a founder or investor, you need a stable number to value long-term projects. If you assume your debt level changes every month, your WACC would constantly fluctuate, making it impossible to value a 5-year plan.
• The “Target” Mix: In reality, companies don’t keep the exact same debt level every day. Instead, they aim for a long-term “target capital structure” (e.g., 20% debt, 80% equity). WACC uses this target mix, ignoring short-term ups and downs.

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Eqvista offers tools and models that automate the calculation of WACC based on the company’s financial data. These tools can handle complex capital structures, multiple debt instruments, and different tax scenarios, ensuring accurate WACC calculations. Eqvista’s WACC calculations can seamlessly integrate various valuation models, such as discounted cash flow (DCF) analysis, enabling more accurate company valuations and investment analysis. Contact us to know more.