WACC is the blended rate a company pays, on average, to finance its assets across both debt and equity, weighted by how much of each it uses. It's the standard discount rate applied to a company's projected free cash flows to value the business.
Why It Matters
WACC is the hurdle rate: any investment or acquisition a company makes needs to generate returns above its WACC to create value, and below it to destroy value. Get WACC wrong in a DCF model — even by a percentage point — and the resulting valuation can shift materially, which is exactly why it's one of the most scrutinized assumptions in any valuation exercise.
How It Works in Practice
- 1Calculate the cost of equity, typically via CAPM (risk-free rate + beta × equity risk premium)
- 2Calculate the after-tax cost of debt (interest rate on debt, adjusted for the tax shield since interest is tax-deductible)
- 3Weight each by its proportion of the company's total capital structure (market value of equity and debt)
- 4WACC = (E/V × cost of equity) + (D/V × after-tax cost of debt), where V = total capital
Common Pitfalls
Using book value instead of market value of equity and debt to calculate the weights is a common and material error
A single static WACC applied across a multi-year projection ignores that capital structure and risk typically change as a company (or deal) matures
Small changes in the assumed beta or equity risk premium can swing WACC — and therefore the entire valuation — more than analysts often acknowledge