Cost of Capitalintermediate

Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) blends the after-tax required returns of every source of financing into one discount rate. It is the rate that discounts the firm’s free cash flow to the firm (FCFF), a cash measure, to estimate enterprise value. The three classic components are interest-bearing debt $k_d$ , preferred equity $k_p$ and common equity $k_e$ , each weighted by its share of total invested capital. Only the debt term is adjusted downward, by the factor $(1 - t)$ , because interest is tax deductible.

Try it yourself

Building the after-tax WACC

A firm's cost of capital is the market-value-weighted blend of what debt and equity holders require: WACC = w_d·k_d·(1 − T) + w_e·k_e. Equity is priced by the CAPM, k_e = r_f + β·ERP, while debt is taken after the interest tax shield, k_d·(1 − T). Only debt earns the shield, so it usually sits below equity in the blend.

Weighted average cost of capital7.50%

Cost of equity k_e 9.50%After-tax k_d 4.50%WACC 7.50%

Weight of debt w_d40%

Equity weight w_e = 60%

Pre-tax cost of debt k_d6.0%

Tax rate T25%

Cost of equity (CAPM)

Risk-free rate r_f4.0%

Equity beta β1.10x

Equity risk premium ERP5.0%

Equity costs 9.50% (=4.0% + 1.10x × 5.0%), debt costs 4.50% after the 25% shield. Blended at 40/60 they give a WACC of 7.50%.

Try this

Shift weight toward debt and WACC usually falls, because shielded debt is cheaper than equity. Raising the tax rate deepens the shield and lowers the after-tax cost of debt.

Note: only debt carries the (1 − T) tax shield, since interest is tax-deductible and dividends are not. The weights w_d and w_e should be market values of debt and equity, not book values, because WACC is the return the market requires today.

Reflect: if cheap shielded debt always lowers WACC, why not finance the firm almost entirely with debt? What does this model leave out about how k_d and k_e respond as leverage climbs?

Why it matters

Every dollar a firm invests is funded by a mix of lenders, preferred holders and shareholders, and each group demands its own return. The WACC is the single hurdle that satisfies all of them at once. Beat it and the project creates value, fall short and the firm destroys value. The rule is blunt. If a project earns less than the cost of raising the funds, the firm is poorer for doing it.

Formulas

WACC with three sources

WACC = w_d\,k_d\,(1 - t) + w_p\,k_p + w_e\,k_e

Here

w_d, w_p, w_e

are the market-value weights of debt, preferred and common equity, summing to one. The tax adjustment

(1 - t)

applies only to debt, since interest is deductible while dividends are not.

FCFF discounted at WACC

V_{firm} = \sum_{t=1}^{n} \dfrac{FCFF_t}{(1 + WACC)^t} + \dfrac{TV_n}{(1 + WACC)^n}

WACC discounts free cash flow to the firm, which is a cash flow available to all capital providers, never accounting net income. The terminal value

TV_n

captures cash beyond the explicit horizon.

Worked examples

Scenario

Consider a firm acquiring OfficeMart, with a capital structure of 40 percent debt and 60 percent equity, a pre-tax cost of debt of 5 percent, a cost of equity of 14 percent and a tax rate of 20 percent. There is no preferred stock. What is the WACC?

Solution

Apply the formula with two sources. The after-tax debt cost is 5 percent times $(1 - 0.20)$ , which is 4 percent. Weighted, the debt contributes $\,0.40 \times 4\% = 1.6\%$ and the equity contributes $\,0.60 \times 14\% = 8.4\%$ . Adding them gives a WACC of 10 percent. OfficeMart’s level FCFF of US$560,000 discounted at 10 percent as a perpetuity gives an enterprise value of US$5.6 million.

Common mistakes

✗WACC uses book-value weights from the balance sheet. Use market-value weights, because they show the real importance of each source of financing right now.
✗You tax-adjust every component. Only the cost of debt is multiplied by $(1 - t)$ . Equity and preferred dividends are paid from after-tax profit, so they carry no shield.
✗WACC discounts net income. It discounts free cash flow to the firm, a cash measure built from after-tax EBIT, never accrual earnings.
✗One WACC fits every project a firm runs. The firm WACC reflects the firm’s average risk. A project with different risk needs a project-specific rate, which is the subject of the required-returns cluster.

Revision bullets

•WACC blends after-tax costs of debt, preferred and equity by market-value weights
•Only the debt term carries the $(1 - t)$ tax shield
•It is the discount rate for free cash flow to the firm (FCFF), a cash measure
•Three steps: set weights, estimate each component cost, take the weighted average
•Use target weights if the capital structure is expected to change
•OfficeMart check: 0.4(5%)(0.8) + 0.6(14%) = 10%

Quick check

A firm is financed 30 percent by debt and 70 percent by equity. The pre-tax cost of debt is 6 percent, the cost of equity is 12 percent and the tax rate is 25 percent. The WACC is closest to

Why is only the cost of debt adjusted by the factor $(1 - t)$ in the WACC?

Connected topics

Cost of Equity (CAPM)Cost of Debt Capital Weights Project vs Firm Rate Enterprise DCF

Sources

Titman & Martin
Titman, S. & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.
Chapter on estimating a firm’s WACC. The three-step procedure and the FCFF-WACC link follow this text, illustrated with the Champion Energy and OfficeMart examples.
Fernández (2011)
Fernández, P. WACC: Definition, Misconceptions and Errors. IESE Business School Working Paper, 2011.
Catalogues common WACC errors, including book-value weighting and inconsistent tax treatment.

How to cite this page

Dr. Phil's Quant Lab. (2026). Weighted Average Cost of Capital (WACC). Derivatives Atlas. https://phucnguyenvan.com/concept/sabv-wacc

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