Cost of capital and WACC
Investors who fund a company expect a return. That required return is the company's cost of capital. It is both the discount rate in a valuation and the hurdle every new project should beat.
Cost of debt
The interest rate the company pays (or would pay today) on its borrowing. Because interest is tax-deductible, the effective cost is lower:
After-tax cost of debt = interest rate × (1 − tax rate)
Cost of equity
Shareholders have no contractual return, so their required return has to be estimated. The most common method is CAPM (lesson 4.3):
Cost of equity = risk-free rate + beta × equity risk premium
With a 4.5% gilt yield, a beta of 1.2 and a 5% equity risk premium, the cost of equity is 10.5%. Equity is always more expensive than debt, because shareholders are paid last.
WACC
The weighted average cost of capital blends the two by how much of each the company uses:
WACC = (E ÷ V) × cost of equity + (D ÷ V) × after-tax cost of debt
where E is equity value, D is debt and V is the total. A company funded 70% by equity at 10.5% and 30% by debt at 4% after tax has a WACC of about 8.5%.
Why it matters
- Value creation: a business creates value only if its return on invested capital (ROIC) exceeds its WACC. Growth at returns below WACC destroys value, however impressive revenue looks.
- Valuation: WACC is the discount rate in most DCF models. Small changes swing the result a lot.
- Capital structure: adding some cheap debt can lower WACC, but too much raises the cost of both debt and equity as risk rises (lesson 1.7).
Key takeaway
WACC is the price of the money a company uses. Comparing it with ROIC is one of the clearest tests of whether management is creating or destroying value.
Educational content only, not financial advice. Investing involves risk and you can lose money.