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Check eligibilityWhat WACC is
WACC blends what lenders charge with what shareholders expect, in proportion to how much of each the company uses. It rests on four inputs.
1
Cost of equity: the return shareholders expect for the risk of owning the business.
2
Cost of debt: the interest rate the company pays on its borrowings.
3
Tax rate: interest is tax-deductible, so debt costs less after tax than its headline rate.
4
Capital mix: the share of total funding that comes from equity and from debt.
Because equity usually costs more than debt, a company's WACC sits between its after-tax cost of debt and its cost of equity.
When to use WACC
WACC is the right rate when a decision carries the same risk as the business as a whole. When it doesn't, another rate fits better.
WHAT CHANGES
Use WACC
Use another rate
Capex decisions
Expanding what you already do
Entering a much riskier line of business
Valuations
Valuing the business as a whole
Valuing a unit with very different risk
Lease or buy
Judging whether the project pays
Comparing funding: use the after-tax cost of debt
Funding mix
Stable
Changing sharply
How to calculate WACC
Weight each cost by its share of total capital and add them up: WACC = (E ÷ V) × cost of equity + (D ÷ V) × cost of debt × (1 − tax rate), where E is equity, D is debt and V is the two combined.
Cost of equity.
Usually estimated with the capital asset pricing model: the risk-free rate plus a premium for the risk of the business.
Cost of debt.
The rate the company would pay to borrow today, reduced by the tax saved because interest is deductible.
Use market values for debt and equity where you can, not book values.
Where WACC is used
Setting the hurdle for a new production line
ILLUSTRATIVE
A manufacturer is funded by ₹60 crore of equity, on which shareholders expect 16%, and ₹40 crore of debt at 10%. At a 25% tax rate, the debt costs 7.5% after tax. Its WACC is (60% × 16%) + (40% × 7.5%) = 12.6%. The CFO uses 12.6% as the hurdle rate: a new production line has to return more than that each year to add value. The same rate is used to value the business and to screen every major capex plan.