The Weighted Average Cost of Capital 

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The weighted average cost of capital, or WACC, is used in valuing companies.  

A standard approach to valuing companies, often called the discounted cashflow or DCF method, is first, to estimate the cashflows that the company will generate in future, then discount them at the weighted average cost of capital or WACC.  

In this DCF method, most of the work goes into estimating the cashflows. This requires a good understanding of the company, the industry or sector in which it operates, its corporate strategy, market positioning and the wider macroeconomic outlook, among other things.  This is a lot of work!

Our goal is to estimate free cashflows to the firm, meaning the cashflows left over (if any) after all revenues and costs (including capital spending and changes in working capital) are taken into account. We say “to the firm” because we ignore debt servicing costs in this calculation. We essentially work out the value of the firm as if it were unlevered, meaning it has no debt; then we deduct the value of any actual debt to get the equity value. And when we say “firm” we mean corporation or company. 

So the weighted average cost of capital, the WACC, is the discount rate used to discount the forecast cashflows of a company. What actually is it? 

The cost of capital: the opportunity cost of investors’ funds in the company

The cost of capital is the return that a representative, rational investor would require for putting their money into a project or company, given the level of expected risk. We say cost, because we mean the opportunity cost, the alternative return that an investor might expect on some other alternative investment that they cannot make if they put their money into this project. 

There are two general types of capital: equity and debt. Each is a different kind of contract between the company and outside providers of capital. Equity is riskier, because it only gets what’s left over after all other claims on the company’s cashflow are met, including the servicing of debt. Debt is therefore less risky than equity. Since we expect higher risks to go with higher expected returns, the expected return on equity is higher than that of debt.  

Debt also has the advantage that the interest payments to debt investors are treated like any other business expense and are tax deductible. This is usually not true of equity, though there are exceptions in some countries. 

Any company or corporation must have equity, because this is the capital from the owner or owners. It’s not necessary for a company to have debt, but the majority have some.

Suppose a company is funded by a mixture of debt and equity. The overall or blended return that investors need for the company to at least meet their cost of capital is a mix of the cost of debt and the cost of equity, weighted according to the relative share of the two types of capital. This is called the weighted average cost of capital. 

It consists of: the cost of debt, adjusted to take account of the tax benefit of debt, that is to say, the post-tax cost of debt; and the cost of equity, each weighted by their market value, not book value. 

Why use market value? In corporate finance we usually are trying to estimate what “the market” (meaning the sum of all investors and financial decision makers) thinks of an investment. The cost of debt and equity are each based on estimates of what return investors require, for a particular level of risk. 

In calculating the weightings of the cost of equity and debt for the WACC, market values are important because they reflect what is known or believed about the company when we make the calculation.  

The book or accounting value of equity is often uninformative about what the market thinks a company’s equity is worth. It’s not that there’s anything wrong with the accounting principles, but they were drawn up for a world of industrial companies. Today’s companies are often in service industries and a large part of their assets are either intangible (in which case they do appear on the balance sheet, but their valuation is hard to estimate) or they don’t appear on the balance sheet at all. 

Apple, one of the world’s most successful and valuable companies, in mid 2026 had a market value of equity about 40 times the book value of its equity. Most of what makes the company valuable is not shown on the balance sheet, including its design skills, supply chain relationships and the unique set of internal relationships that allows the company to keep producing great products that people are willing to pay a high price for. 

So, if we used the book value of Apple’s equity, we would lose information about the market’s perception of the company.  

The problem is less serious with debt, because book and market values tend to be more similar. In general, analysts take the book value of debt when calculating the WACC, unless there is a good reason not to do so. One case you might not use the book value of the debt is if a company is in financial distress. In that case, the market value of the debt may be lower than the book value (meaning investors are not confident that they will be fully repaid). So it would be right to take the market value of the debt in this situation. Taking the market rather than book value of the debt would imply a lower weighting for the debt in the WACC calculation than would otherwise be the case. Since the cost of debt is always lower than the cost of equity, this in turn would imply a higher WACC, which is consistent with a company in financial distress, when the cost of capital should indeed be higher, as the risk is higher. 

Finally, just how do we work out the cost of debt and cost of equity? We use our capital asset pricing model or CAPM framework, which gives us a clear, though somewhat imprecise method for estimating the cost of equity. The three components are: i) the risk-free rate; ii) the estimated equity risk premium (the return needed to compensate investors for bearing equity risk in general); and iii) the beta, which is a measure of the individual company’s equity risk compared with the market as a whole. 

For the cost of debt, we take the risk-free rate and then either estimate the additional return investors need for bearing the additional risk of the company above that of the risk-free rate, or if the company has debt already trading in the market in the form of corporate bonds, we can observe the market’s required return directly. 

Once we have our estimated WACC, and if we have already estimated the future free cashflows to the firm, then we have all we need to estimate the value of the company.  

Use the actual WACC or the optimal WACC?

When we calculate the WACC for a company, we normally use the actual, existing levels of debt and equity, meaning the capital structure. But what if we think this is not the optimal WACC? The optimal WACC is the lowest achievable WACC, which means the combination of debt and equity that would achieve the best – meaning lowest – opportunity cost for the external investors’ capital. Should we use that optimal WACC for valuing the company?

Normally for a public company, meaning one that is trading on a stock exchange, the answer is no – we should use the actual debt/equity mix the company has, even if we think the company could in principle raise its value by changing that mix, to achieve a lower WACC. Typically this is where we could argue the company is under-levered, meaning it has too little debt. Since debt typically brings a tax benefit, more debt is better, but only up to the point where the risk of financial distress starts to rise, which offsets the tax benefit of more debt – this model is known as the trade-off theory of capital structure.

The trouble is that a public company has chosen its debt/equity mis and therefore its WACC. We may disagree with that choice but unless there is a good reason to think the company will actually change its debt/equity mix, we should use the actual mix and therefore the actual, current WACC.

But for private equity investors, who are considering buying a company and then changing the debt/equity mix, they should definitely estimate the additional value from moving to a better (lower) WACC by increasing the debt/equity ratio. It’s precisely because they will have control of the company, including the capital structure, that private equity valuations should take changing the WACC into account.