WACC
Weighted average cost of capital
WACC is the average return a company must earn on its capital to satisfy both its lenders and its shareholders, weighted by how much of each it uses. It is the discount rate in a DCF of free cash flow to the firm.
Formula
WACC
WACC = (E ÷ (D + E)) × Ke + (D ÷ (D + E)) × Kd × (1 − Tax rate)
Cost of equity (CAPM)
Ke = Risk-free rate + Beta × Equity risk premium
Benchmark: A hurdle, not a score: compare it with return on invested capital
Variables
| E | Market value of equity (market capitalisation) |
| D | Value of debt; book value of borrowings is the usual stand-in |
| Ke | Cost of equity, the return shareholders require |
| Kd | Pre-tax cost of debt, the interest rate the company pays on new borrowing |
| Tax rate | The company's effective tax rate; interest is tax-deductible, so debt costs less after tax |
Finding the inputs
Market capitalisation from the exchange. Borrowings from the balance sheet. The cost of debt from the finance costs note, divided by average borrowings, or the yield on the company's bonds. The effective tax rate from the tax note. Beta from a regression of the stock's returns against the index, or an average of listed peers. The risk-free rate from the 10-year Government of India bond yield.
Reading the number
WACC is the minimum return the business needs to earn on all its capital. Lenders need their interest; shareholders need a higher return because they are paid last and carry more risk. Debt is cheaper than equity for two reasons: lenders are paid first, and interest is tax-deductible, which is why the cost of debt is taken after tax.
It has two main uses. In a DCF, WACC is the discount rate for free cash flow to the firm, and the value is very sensitive to it: a one-point change can move value by 10% to 25%. In performance analysis, it is the hurdle: a company creates value only when its return on invested capital is above its WACC.
Use market values for the weights where you can, because the question is what investors could earn elsewhere today, not what they paid years ago. Every input is an estimate, so report WACC as a range rather than as a precise figure.
Illustrative example
Related ratios
Glossary terms
From the research
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