How to Calculate WACC, Step by Step
WACC is the discount rate a DCF runs on: the blended return required by a company's equity and debt holders together. Here is how to build it from CAPM through the after-tax cost of debt to the final weighted number.
What is WACC?
WACC is the blended after-tax return a company must earn to satisfy every provider of its capital. It weights the CAPM cost of equity and the after-tax cost of debt by each one's market-value share of total capital. A DCF discounts unlevered free cash flow at WACC because that cash belongs to debt and equity holders together.
Key takeaways
- WACC = (E ÷ V) × cost of equity + (D ÷ V) × cost of debt × (1 − tax rate).
- Cost of equity comes from CAPM: risk-free rate + beta × equity risk premium.
- Only the cost of debt is tax-affected, because interest is tax-deductible and dividends are not.
- Weights use market values, not book values, because WACC is meant to reflect today's cost of raising capital.
- Adding debt lowers WACC at first through the tax shield, then raises it once financial risk pushes up both the credit spread and the equity beta.
What is WACC, and why is it the rate a DCF discounts at?
- Weighted average cost of capital (WACC)
- The blended rate of return a company must earn on its assets to satisfy both its debt holders and its equity holders, with each component cost weighted by that component's share of total capital at market value.
The weighted average cost of capital is the blended return a company must earn on its assets to satisfy everyone who has supplied it capital: equity holders and debt holders both. It is called for whenever the cash flow being valued belongs to both groups, which is exactly the case for unlevered free cash flow in a DCF. Using only the cost of equity to discount a cash flow that also belongs to debt holders would understate the true required return and overstate the resulting valuation.
where E is the market value of equity, D is the market value of debt, and V is the two combined (E + D). Each piece of that formula is built up separately below.
How do you calculate the cost of equity?
The cost of equity is estimated with the Capital Asset Pricing Model (CAPM), which says equity investors require the risk-free rate plus compensation for the stock's exposure to overall market risk:
The risk-free rate is typically the yield on a long-term government bond. Beta measures how much a stock tends to move relative to the overall market; a beta above 1.0 means the stock is more volatile than the market, below 1.0 means less. The equity risk premium is the extra return equity investors demand, historically, for holding stocks over a risk-free asset.
Worked example: a 3% risk-free rate, a beta of 1.2, and a 5.5% equity risk premium.
A common refinement compares beta across several similar public companies rather than relying on one company's own noisy beta: unlever each comparable company's beta to strip out its specific capital structure, average the unlevered betas, then relever that average at the subject company's own target capital structure.
How do you calculate the after-tax cost of debt?
The pre-tax cost of debt is usually estimated as the risk-free rate plus a credit spread reflecting the company's default risk, or read directly off the yield on the company's existing bonds if they trade actively. Because interest expense is tax-deductible, the pre-tax cost has to be tax-affected before it enters WACC, applying the same tax shield logic used throughout unlevered free cash flow:
Worked example: a 3% risk-free rate plus a 3% credit spread gives a 6% pre-tax cost of debt; at a 25% tax rate, the after-tax cost of debt is 6% × (1 − 0.25) = 4.5%.
How do you weight debt and equity in WACC?
The weights in WACC use the market value of debt and equity, not their book (balance sheet) values. Equity's market value is share price times diluted shares outstanding; debt's market value is usually approximated with its book value unless the debt trades and a market price is available.
Full worked example: equity has a market value of $700mm and debt has a market value of $300mm, so total capital is $1,000mm, a 70/30 split. Cost of equity is 9.6% (from above) and the after-tax cost of debt is 4.5% (from above).
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Common WACC interview questions
Why is the cost of debt tax-affected in WACC but the cost of equity isn't?
Interest expense is tax-deductible, so every dollar of interest a company pays actually costs it less than a dollar once the resulting tax savings are counted. Dividends paid to equity holders are not tax-deductible, so there is no equivalent shield to apply to the cost of equity.
Why use market value weights instead of book value weights?
WACC is meant to reflect the actual current cost of raising each type of capital today, and market value is what investors would actually have to pay (or receive) to hold that equity or debt right now. Book value reflects historical accounting figures that can be far out of date, especially for equity.
What does it mean if a company's beta is greater than 1?
A beta above 1.0 means the stock has historically moved more than the overall market, amplifying both gains and losses; a beta below 1.0 means it has moved less. CAPM uses beta to scale the equity risk premium up or down for that specific stock's market risk.
Why unlever and relever beta using comparable companies?
A single company's own historical beta can be noisy and reflects that company's specific capital structure at the time. Unlevering strips leverage out so betas across several comparable companies can be fairly averaged, and relevering the average at the subject company's own target capital structure gives a beta appropriate to the company actually being valued.
If a company raises more debt, what happens to its WACC?
It depends on the level of leverage. Initially, adding cheaper, tax-advantaged debt in place of more expensive equity tends to lower WACC. Beyond a point, more debt raises financial risk, pushing up both the cost of debt (through a wider credit spread) and the cost of equity (through a higher equity beta), which can eventually raise WACC despite debt's tax shield.