Weighted Average Cost of Capital (WACC)

WACC = (E/V) × Ke + (D/V) × Kd × (1 - T). E = market value of equity, D = market value of debt, V = E + D (total capital), Ke = cost of equity, Kd = cost of debt, T = corporate tax rate. The (1 - T) term on debt reflects the tax deductibility of interest — because interest payments reduce taxable income, the after-tax cost of debt is lower than the stated coupon rate. This tax shield is one of the key benefits of leverage.

The cost of equity is typically calculated using the Capital Asset Pricing Model: Ke = Rf + β × (Rm - Rf). Rf = risk-free rate (10-year Treasury yield, typically 4–5%). β (beta) = the stock's sensitivity to market movements (1.0 = moves with the market). Rm - Rf = equity risk premium (historically 5–7% for U.S. stocks). For a company with β = 1.2, Rf = 4.5%, and ERP = 6.0%: Ke = 4.5% + 1.2 × 6.0% = 11.7%. Small-cap and country risk premiums are added when appropriate.

The cost of debt is the yield at which the company can currently borrow, not the historical coupon rate on existing debt. For investment-grade companies, look at yields on comparable-maturity corporate bonds. For leveraged companies, use the yield to maturity on their existing bonds or the spread implied by their credit rating. The pre-tax cost of debt for an investment-grade company is typically 4–6%, while leveraged/high-yield borrowers pay 6–10%+. After the tax shield, effective cost is 25–30% lower.

Most U.S. companies have a WACC between 8% and 12%. Tech companies (with high equity weightings and betas above 1) tend to have higher WACCs. Utilities (with stable cash flows, low betas, and significant debt) tend to have lower WACCs. In modeling, use the target (optimal) capital structure rather than the current one — this reflects the long-term mix the company will maintain. For LBOs, don't use WACC as the discount rate — use the PE firm's required return (cost of equity), since the DCF in an LBO is for equity holders only.