Every company has two types of capital: debt (borrowed from banks or bond markets) and equity (owned by shareholders). Each comes with a cost — lenders charge interest; shareholders expect a return that compensates them for the risk of owning the business. WACC blends these two costs into a single rate, weighted by how much of each the company uses.
The formula
Where: E = market value of equity, D = market value of debt, V = E + D (total capital), Re = cost of equity, Rd = cost of debt, Tax Rate = corporate tax rate.
Debt gets a tax adjustment (1 − Tax Rate) because interest payments are tax-deductible — the government effectively subsidises debt financing.
Breaking down each component
Cost of debt (Rd): Relatively straightforward — it's the yield on the company's outstanding bonds or the interest rate on its loans. Observable from market data.
Cost of equity (Re): Much harder to estimate — shareholders don't have a contractual payment. The standard approach is CAPM: Re = Risk-Free Rate + Beta × Market Risk Premium. The market risk premium (typically 5–7%) is the extra return equity investors demand over cash.
A worked example
| Component | Value | Weight | Contribution |
|---|---|---|---|
| Equity (market cap £600m) | 12% (cost) | 60% | 7.2% |
| Debt (£400m at 5% rate) | 5% × (1−25%) | 40% | 1.5% |
| WACC | 100% | 8.7% |
What WACC tells you about investment decisions
If a company's WACC is 8.7%, then any project it invests in must earn more than 8.7% to create value. Investing in a project earning only 6% would destroy value — the company would be better off returning the capital to shareholders. This is why WACC is also called the hurdle rate.
What this means for you
In DCF valuation, a small change in WACC has an enormous impact on the result. A company valued at £100/share with a 10% WACC might be valued at £140 with an 8% WACC. When interest rates rise, WACCs rise — and DCF valuations fall. This is one of the core reasons why high-growth companies (whose value is concentrated in distant future cash flows) are most sensitive to interest rate moves: higher rates mean a higher WACC, which discounts those future flows more heavily.