WACC: the discount rate, explained
“What is WACC, and how do you calculate it?”
The formula is easy to memorize. The interviewer wants the intuition: whose return it represents, why debt is taxed, and why equity costs more.
WACC is the return all of a company's investors require, weighted by how much each funds the business. It's the hurdle the operations must clear.
The formula, read as a sentence
WACC = (equity share × cost of equity) + (debt share × cost of debt × (1 − tax rate)). Read it as: “of every dollar funding this business, part comes from shareholders wanting X%, part from lenders wanting Y%, and lenders' cost is cheaper after the tax deduction on interest.”
Cost of equity with CAPM
Shareholders want the risk-free rate (a long-term government bond yield) plus extra for risk: beta × equity risk premium. Beta measures how much the stock swings with the market; a beta of 1.3 means it tends to move 30% more than the market.
- 1Cost of equity = 4.5% + 1.3 × 5% = 11.0%.
- 2After-tax cost of debt = 7% × 0.75 = 5.25%.
- 3WACC = 0.75 × 11.0% + 0.25 × 5.25% = 8.25% + 1.31% ≈ 9.6%.
Why equity costs more than debt
Lenders get paid first, have contracts, and often have collateral. Shareholders get what's left, if anything. More risk demands a higher return, so equity is the most expensive capital. Debt is cheaper still after tax, because interest is deductible.
Dashed: cash flow that year. Filled: what it's worth today. The further out, the more it shrinks.
Try dragging WACC and watch EV.
“If debt is cheaper, why not use all debt?” Because more debt makes both lenders and shareholders demand more. Past a point, WACC rises again, and bankruptcy risk becomes real.
Say it like this
WACC is the weighted average of the returns a company's equity and debt investors require, weighted by their share of the capital structure. The cost of equity usually comes from CAPM: the risk-free rate plus beta times the equity risk premium. The cost of debt is the company's borrowing rate multiplied by one minus the tax rate, since interest is tax-deductible. Because it reflects all capital providers, it's the right discount rate for unlevered free cash flow.
Traps to avoid
- ✕Forgetting the (1 − tax rate) on the cost of debt.
- ✕Using book weights instead of market or target weights.
- ✕Saying equity is cheaper because “there's no interest”. Shareholders demand the highest return.
What they'll ask next
›What's WACC for a company with no debt?
Just its cost of equity, since equity is 100% of the capital structure.
›How do you get WACC for a private company?
Borrow from public peers: unlever their betas, relever at a target capital structure, then apply CAPM and a market-based cost of debt.
›Why unlever and relever beta?
Peers carry different debt loads, which distorts their equity betas. Unlevering isolates business risk; relevering applies your company's own leverage.
Check yourself
60% equity at a 10% cost of equity, 40% debt at a 5% pre-tax cost of debt, 25% tax rate. What's WACC?
Put it all together
Build a full five-year DCF and decide if the stock is cheap.