What is WACC?
If you are an entrepreneur, one of your primary objectives is to increase your company's value. To do that, you often need a lot of startup capital to make necessary purchases or get your business off the ground.
There are many potential sources of capital: common and preferred stocks, bonds, or debts. They are generally divided into two categories: equity, which is the total value of all assets, and debt, which is the money you borrowed.
The capital gained through equity or debts comes at a certain cost. The cost of debt is pretty straightforward — you always have to give back more money than you borrowed. The proportion between borrowed and returned capital is expressed with an interest rate. For example, if the interest rate is 8%, you have to return $108 for every $100 you borrow.
In the case of the cost of equity, the calculations are not so straightforward. Generally, it is assumed that the cost of equity is all the expenses you need to bear to convince your stakeholders that your company is worth investing in. If your stakeholders don't feel they are receiving reasonable compensation for the risk they are taking, they will likely sell their shares, which will decrease your company's value.
If your company gained financing from both equity and debt, then you need to combine the cost of debt and the cost of equity in one metric to determine whether it will be profitable enough. This metric is called WACC — the Weighted Average Cost of Capital.
If your company's rate of return is higher than the WACC, it is profitable. If the rate of return is lower, your financing costs are not covered, which usually means you're in deep trouble.
WACC Formula
If you want to calculate the WACC for your company, you need to use the following formula:
WACC = E / (E + D) × Ce + D / (E + D) × Cd × (1 − T/100)
Where:
- WACC — Weighted Average Cost of Capital, expressed as a percentage
- E — Equity (total value of shareholders' equity)
- D — Debt (total outstanding debt)
- Ce — Cost of equity (%)
- Cd — Cost of debt (%)
- T — Corporate tax rate (%). The tax rate accounts for the tax deduction on interest paid.
How to Calculate WACC?
Here is a step-by-step example of how to calculate WACC:
- Determine how much of your capital comes from equity. For example, you have $700,000 in equity.
- Write down your debts. For instance, you might have taken a loan of $500,000.
- Estimate the cost of equity. Let's assume it is equal to 15%.
- Check the cost of debt. For example, the interest rate on your loan might be equal to 8%.
- Decide on the corporate tax rate. We will assume it is 20%.
- Apply the WACC formula:
WACC = $700,000 / ($700,000 + $500,000) × 15% + $500,000 / ($700,000 + $500,000) × 8% × (1 − 20%) WACC = 0.583 × 15% + 0.417 × 8% × 0.8 WACC = 8.75% + 2.67% WACC = 11.42%
This value of WACC can be used in further calculations as the cost of capital. For example, you can apply it in discounted cash flow (DCF) analysis or net present value (NPV) calculations.
How to Interpret WACC?
| WACC Range | Interpretation |
|---|---|
| < 5% | Very low cost of capital — very cheap financing, typical for extremely stable companies or government-backed firms. |
| 5% – 8% | Low cost of capital — below industry average, indicating efficient and low-risk financing. |
| 8% – 12% | Normal — typical WACC range for most companies across various industries. |
| 12% – 15% | High — above-average financing costs, often seen in growth companies or riskier industries. |
| > 15% | Very high — expensive capital, indicating significant financial risk or early-stage startups. |
Tips for Using WACC
- Use WACC as a hurdle rate. When evaluating investments, compare projected returns to WACC. Only invest if expected returns exceed WACC.
- Tax shield on debt. The formula accounts for the tax deductibility of interest payments, which reduces the effective cost of debt.
- Optimize your capital structure. Balancing equity and debt can help minimize WACC, thereby maximizing company value.
- Industry benchmarks matter. Compare your WACC to industry averages — a high WACC in a low-risk industry is a warning sign.
- Update regularly. Market conditions, interest rates, and tax laws change — recalculate WACC periodically.