The weighted average cost of capital is the blended return a company must earn to satisfy everyone who funds it — both lenders and shareholders. It weights the cost of each source of capital by how much of the financing it provides, giving a single percentage that represents the company’s overall cost of money.
In valuation, WACC is the discount rate: the rate used to shrink future cash flows back to what they are worth today. A higher WACC means future cash is discounted more heavily, and the business is worth less now.
E = market value of equity, D = market value of debt, V = E + D, Re = cost of equity, Rd = cost of debt, Tc = corporate tax rate. The (1 − Tc) term reflects that interest is tax-deductible.
Suppose a company is financed with $6,000M of equity at a 9% cost of equity and $4,000M of debt at a 5% cost of debt, with a 21% tax rate. Equity is 60% of the total and debt 40%:
Roughly 7% is the hurdle this company’s investments must clear to create value — and the rate you would discount its projected cash flows at in a DCF.
Treat WACC as the hurdle rate: projects and returns above it create value for owners, while those below it destroy it. In a discounted-cash-flow model it is the discount rate applied to every projected year and to the terminal value.
Because valuations are highly sensitive to it, it is worth testing a range of WACC assumptions rather than trusting a single point estimate.
WACC is central to intrinsic valuation and to capital-allocation decisions — whether to take on a project, issue debt, or buy back stock. Any DCF-based estimate of fair value rests on it.
The cost of equity cannot be observed directly — it is estimated, usually via CAPM, which makes WACC sensitive to inputs like beta and the equity risk premium. It also assumes a stable capital structure, and small changes in the rate swing valuations substantially. Precise-looking WACC figures carry real uncertainty.