Weighted average cost of capital (WACC) is the blended required return of everyone who finances a company: equity holders and debt holders, weighted by how much of the capital structure each provides. It answers a simple question: what return must this company earn on its assets so that every investor gets the return they require for the risk they are taking?
WACC is the discount rate for unlevered free cash flow in a DCF. Unlevered FCF is the cash flow available to all capital providers before any financing payments, so it must be discounted at a rate that blends all of their required returns. The matching principle runs through everything here: unlevered FCF pairs with WACC, levered FCF pairs with the cost of equity.
The WACC Formula
WACC = (E/V) ร Ke + (D/V) ร Kd ร (1 - T). Take it component by component.
- E is the market value of equity, which for a public company is the market capitalization: diluted shares outstanding times the current share price
- D is the market value of debt; in practice, book value serves as a proxy when the debt trades near par
- V is E + D, total capitalization, so E/V and D/V are the weights
- Ke is the cost of equity, the return equity investors require, almost always estimated with CAPM
- Kd is the pre-tax cost of debt, the rate the company would pay to borrow today
- (1 T) converts the cost of debt to an after-tax figure, because interest is tax-deductible and the deduction shields income from tax
If the company has preferred stock, add a third term: the preferred's share of total capitalization times its cost, with no tax adjustment because preferred dividends are not deductible.
Cost of Equity and CAPM
The cost of equity is estimated with the Capital Asset Pricing Model: Ke = Rf + ฮฒ ร ERP.
The risk-free rate (Rf) is a long-dated Treasury yield, usually the 10-year and sometimes the 20-year, chosen to match the duration of the cash flows being discounted. Suppose the 10-year Treasury yields 4.25%; that is your starting point.
Beta measures how much the stock moves with the overall market. A beta of 1.0 moves with the market, above 1.0 amplifies market moves, below 1.0 dampens them. Raw betas pulled from a data service are noisy, so the standard fix is to work from comparables: take the levered betas of comparable companies, unlever each one to strip out its capital structure using Unlevered Beta = Levered Beta / (1 + (1 - T) ร D/E), take the median, then re-lever that unlevered beta at the target company's own capital structure by running the formula in reverse. Re-levering matters because leverage amplifies equity risk: the same business carries a higher equity beta at 50% debt than at 10% debt.
The equity risk premium (ERP) is the excess return investors expect from stocks over the risk-free rate. Estimates vary by method, but most practitioners use something in the 5-6% range, with published estimates spanning roughly 4-7%. Valuation groups typically standardize on a house number.
The Size Premium in WACC
CAPM tends to understate the required return for small companies. Historically, small-cap stocks have earned returns above what their betas alone would predict, so valuation practitioners add a size premium to the CAPM result for smaller companies. Published size-premium data expresses this as an addition by market-cap decile: as an illustration, a mid-cap company might get 0.5-1.0% added, a small-cap company 1-3%, and micro-cap companies more than that.
The size premium appears most in private company valuation, fairness opinions, and middle-market work, where targets are far smaller than the large caps CAPM was calibrated on. Adding it raises the cost of equity, which raises WACC, which lowers the DCF value. The premium is debated academically, and some researchers argue it has weakened in recent decades, but you should know what it is and which direction it moves the answer. Interviewers use it to test whether you understand that WACC inputs are judgment calls rather than settled constants.
Cost of Debt
The cost of debt is what the company would pay to borrow today, not the coupon on debt it issued years ago. For a company with traded bonds, use the yield to maturity on its longer-dated issues. For a company with mostly bank debt, use the current rates on its facilities, or build the rate as the risk-free rate plus the credit spread appropriate for its rating. For a private company, look at where similarly rated or similarly levered comparables borrow.
Then tax-affect it. Interest expense is deductible, so the government effectively pays part of the interest bill. At a 5.8% pre-tax rate and a 24% tax rate, the after-tax cost is 5.8% ร (1 - 0.24) = 4.4%. Debt is cheaper than equity even before the tax break, because lenders take less risk: they are paid contractually and stand ahead of shareholders in a bankruptcy. The tax shield widens the gap.
One caveat worth knowing: the deduction only has value if the company has taxable income to shield, and US rules cap interest deductibility for heavily levered companies, so the full (1 - T) benefit is not automatic at extreme leverage levels.
Capital Structure Weights
Use market values, not book values. The weights should represent the economic mix of capital at today's prices and today's required returns. Book equity is an accounting residual, historical paid-in capital plus retained earnings, and it can sit far from what the equity is actually worth. A company with a $10B market cap and $3B of book equity gets weighted on the $10B, because that is the value of the claim equity investors actually hold.
For debt, book value is usually an acceptable proxy because debt is a contractual claim that tends to trade near par. Mark it to market when it trades at a deep discount, which mainly happens for distressed credits.
Conceptually, the weights should reflect the target capital structure the company will maintain over the long run, since the DCF discounts long-run cash flows. In practice, analysts use the current market-value mix as the default and sanity-check it against the industry median and management's stated intentions. For a private company with no observable equity value, borrow the capital structure of the public comparables.
How to Calculate WACC: Worked Example
Suppose a company has an $8B market cap and $2B of debt. Walk the calculation in four steps.
- Weights: V = $10B, so E/V = 80% and D/V = 20%
- Cost of equity: with a 4.25% risk-free rate, a re-levered beta of 1.15, and a 5.5% equity risk premium, Ke = 4.25% + 1.15 ร 5.5% = 10.58%
- Cost of debt: the company's bonds yield 5.8% pre-tax; at a 24% tax rate, after-tax Kd = 5.8% ร 0.76 = 4.41%
- Combine: WACC = 0.80 ร 10.58% + 0.20 ร 4.41% = 8.46% + 0.88% = 9.34%, call it roughly 9.3%
In an interview, narrate the steps rather than reciting the formula. Saying where each input comes from, market cap for E, Treasury yield for Rf, re-levered comp betas for beta, bond yields for Kd, demonstrates that you could actually build the analysis. If the company were private, you would take beta and the capital structure from comparables and consider a size premium on the cost of equity.
WACC in a DCF
In a standard DCF you project unlevered free cash flow for five to ten years, discount each year at WACC, and add a discounted terminal value; the sum is enterprise value. Subtract net debt to reach equity value. If you instead discounted levered free cash flow, cash flow after interest, you would use the cost of equity and arrive directly at equity value. Mixing the two is one of the fastest ways to fail a technical round.
The terminal value makes WACC sensitivity enormous. Under the Gordon growth method, Terminal Value = Final Year FCF ร (1 + g) / (WACC - g). Because WACC minus g sits in the denominator, small changes move the answer a lot: with growth at 2.5%, moving WACC from 10.0% to 9.0% shrinks the denominator from 7.5% to 6.5% and raises the terminal value by about 15%. Since terminal value commonly represents 60-80% of total enterprise value, a one-point change in WACC can swing the entire valuation by double digits. That is why every DCF ships with a sensitivity table of WACC against terminal growth or exit multiple, and why bankers present valuation as a range rather than a point estimate.
Common Interview Traps
- Discounting levered FCF at WACC, or unlevered FCF at the cost of equity: always match the cash flow to the claim holders reflected in the discount rate
- Using book value weights: the weights must come from market values
- Forgetting the (1 T) on the cost of debt, or tax-adjusting the cost of equity, which gets no adjustment because dividends are not deductible
- Using a raw beta for a company whose capital structure differs from its comps instead of unlevering and re-levering
- Saying more debt always lowers WACC: it does at first, then distress risk raises both Kd and Ke and WACC turns back up
- Quoting a risk-free rate off a short-term Treasury bill: match the maturity to the long duration of DCF cash flows
- Treating WACC as a fact: it is an estimate built from judgment calls, which is exactly why sensitivity tables exist