Glossary
Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the blended return a company must earn to satisfy all its capital providers, combining the after-tax cost of debt and the cost of equity in proportion to their share of total capital. It is the standard discount rate in a business DCF.
Formula
Example
A company has $60,000,000 of equity and $40,000,000 of debt at market values, so total capital is $100,000,000. Its cost of equity is 12%, its pre-tax cost of debt is 7% and its tax rate is 25%, making the after-tax cost of debt 5.25%. WACC = (0.60 x 12%) + (0.40 x 5.25%) = 7.2% + 2.1% = 9.3%. Projects returning less than 9.3% would reduce value.
How it is used in underwriting
WACC is used to discount a company's unlevered free cash flows in a DCF valuation, to set hurdle rates for capital projects and to evaluate acquisitions. Underwriters estimate the cost of equity, usually with the capital asset pricing model or a build-up method for private companies, add the after-tax cost of debt, and weight them by target or market capital structure. Because enterprise value is highly sensitive to the discount rate, underwriters show valuation ranges across several WACC assumptions and cross-check the DCF result with trading and transaction multiples.
For private companies, WACC estimates involve substantial judgment. Small companies typically carry size and company-specific risk premiums that raise the cost of equity, and book values may differ from market values. A common mistake is using the current capital structure instead of a sustainable target one, or using the cost of debt on old loans rather than current market rates. Lenders rarely use WACC directly, since they price their own loans, but equity investors and M&A advisors rely on it. In real estate, discount rates and cap rates usually replace WACC for valuing individual properties.
Frequently asked questions
Why is the cost of debt after tax in WACC?
Interest expense is generally tax deductible, so the effective cost of borrowing is lower than the stated rate. Multiplying the cost of debt by one minus the tax rate captures this tax shield. Equity returns are not deductible, so the cost of equity is not adjusted.
What is a good WACC?
There is no single good WACC. It depends on interest rates, business risk, size and capital structure. Large, stable companies usually have lower WACCs than small private businesses. What matters is that a company's projects or acquisitions earn returns above its WACC, which creates value for its owners.
How is WACC used in a DCF?
In a discounted cash flow valuation, projected unlevered free cash flows and a terminal value are discounted to present value at the WACC. The sum is enterprise value. Subtracting net debt gives equity value. Because the result is sensitive to WACC, analysts show a range of values across different rates.
Related terms
Underwrite your next deal in minutes
Drop a deck or data room. Underridge returns a verdict, investment memo, term sheet and a live model, with every headline figure traced to a page, a formula or a labeled assumption. Ten underwrites free.
Try Underridge free