What Is WACC?
The Weighted Average Cost of Capital (WACC) represents the minimum rate of return a company must earn on its existing assets to satisfy all of its capital providers — both equity investors and debt holders. It blends the cost of equity and the after-tax cost of debt according to the company's target capital structure.
WACC is the appropriate discount rate for unlevered free cash flows in a DCF analysis because UFCF represents cash available to all capital providers. Using WACC ensures you are discounting those cash flows at a rate that reflects the required return of both debt and equity.
Components of WACC
The cost of equity is typically estimated using the Capital Asset Pricing Model (CAPM): Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium. The risk-free rate is usually the 10-year or 20-year U.S. Treasury yield. Beta measures the stock's sensitivity to market movements. The equity risk premium is the expected excess return of the market over risk-free investments, typically 5-7%.
The cost of debt is the yield the company pays on its borrowings. For public companies, you can observe the yield on their traded bonds. For private companies, you might use the company's weighted average interest rate or comparable credit spreads. The cost of debt is tax-adjusted because interest payments are tax-deductible, creating a tax shield. The after-tax cost of debt = Pre-tax cost of debt × (1 − Tax Rate).
The capital structure weights should reflect the company's target or optimal capital structure, not necessarily its current structure. In practice, many analysts use the current market-value-based capital structure as a proxy for the target structure.
Practical Considerations
Beta estimation requires judgment. Published betas (from Bloomberg, FactSet) are based on historical stock returns and can be noisy. Analysts often unlever the betas of comparable companies and re-lever at the target company's capital structure to get a more accurate estimate.
For the risk-free rate, use a maturity that matches the duration of the cash flows being discounted. Since a DCF projects long-term cash flows, the 10-year or 20-year Treasury yield is appropriate.
Size premiums may be added for smaller companies, as the CAPM may understate their required return. Company-specific risk premiums are sometimes added for private companies, though this is debated among practitioners.
WACC and Capital Structure
WACC is minimized at the optimal capital structure. Adding debt initially reduces WACC because debt is cheaper than equity (due to the tax shield and priority in liquidation). But beyond a certain point, additional debt increases financial distress risk, raising both the cost of debt and equity, and WACC starts to increase.
Common WACC Ranges
For large-cap companies in stable industries, WACC typically ranges from 7-10%. High-growth technology companies may have WACCs of 10-14% due to higher equity betas and less debt capacity. Utilities and regulated businesses often have lower WACCs (5-8%) due to stable cash flows and high debt capacity.
WACC in Interviews
Be prepared to walk through each component and explain the intuition. Know that WACC is used to discount unlevered (not levered) free cash flows. Understand that the tax shield on debt reduces the effective cost of debt. And be ready to discuss how changes in leverage affect each component and the overall WACC.