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WACC Guide - Weighted Average Cost of Capital

Quick answer WACC = (E/V x Re) + (D/V x Rd x (1 - Tc)): the cost of equity and the after-tax cost of debt, each weighted by its share of the capital. A company financed 60% by equity at 12% and 40% by debt at 6%, with a 28% tax rate, has a WACC of 8.93%, and a project must return more than that to create value. The step-by-step working is below.

💼 What is WACC?

Weighted Average Cost of Capital (WACC) represents the average rate a company must pay to finance its assets. It's the blended cost of all capital sources (debt and equity) weighted by their proportion in the company's capital structure.

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                Key Point: WACC is the minimum return a company must earn on its investments to satisfy all investors (both debt holders and shareholders). It's used as the discount rate for evaluating new projects and determining company value. If a project's return exceeds WACC, it creates shareholder value.
            

The WACC Formula

WACC = (E/V × Re) + (D/V × Rd × (1 - Tc))

Where:

E = Market value of equity

D = Market value of debt

V = E + D (total market value)

Re = Cost of equity

Rd = Cost of debt

Tc = Corporate tax rate

Simple Example

Company ABC Capital Structure:

Equity: $6 million (60% of capital)

Debt: $4 million (40% of capital)

Cost of equity (Re): 12%

Cost of debt (Rd): 6%

Tax rate: 28%

WACC = (0.60 × 12%) + (0.40 × 6% × (1 - 0.28))

WACC = 7.2% + 1.73%

WACC = 8.93%

Interpretation: Company must earn at least 8.93% on new investments to satisfy both shareholders and debt holders. Projects with returns below 8.93% destroy shareholder value.

Components of WACC

1. Cost of Equity (Re)

Return shareholders expect for their investment. Calculated using CAPM:

Re = Rf + β × (Rm - Rf)

Rf = Risk-free rate (government bonds)

β = Beta (stock volatility vs market)

Rm = Expected market return

(Rm - Rf) = Market risk premium

Example:

NZ government bond rate: 4.5%

Company beta: 1.2

Market return: 10%

Re = 4.5% + 1.2 × (10% - 4.5%)

Re = 4.5% + 6.6%

Re = 11.1%

2. Cost of Debt (Rd)

Interest rate company pays on borrowings. Use yield to maturity on existing bonds or interest rate on loans.

Total interest expense: $300,000

Total debt: $5,000,000

Rd = $300,000 / $5,000,000

Rd = 6.0%

3. Tax Shield

Debt provides tax benefit because interest is tax-deductible. This reduces the effective cost of debt.

Pre-tax cost of debt: 6.0%

Tax rate: 28%

After-tax cost = 6.0% × (1 - 0.28)

After-tax cost = 4.32%

Tax shield saves 1.68% (6.0% - 4.32%), making debt cheaper than equity.

Why WACC Matters

1. Project Evaluation (Hurdle Rate)

WACC is the minimum acceptable return for capital projects:

Project IRR > WACC → Accept (creates value)
Project IRR < WACC → Reject (destroys value)
Project IRR = WACC → Neutral (break-even)

2. Company Valuation

WACC is the discount rate in DCF (Discounted Cash Flow) valuation:

Company Value = Future Cash Flows / (1 + WACC)^n

3. Capital Structure Optimisation

Companies adjust debt/equity mix to minimise WACC and maximise firm value.

4. Performance Measurement

Economic Value Added (EVA) uses WACC:

EVA = (Return on Capital - WACC) × Capital Invested

Typical WACC by Industry

Industry	Typical WACC	Characteristics
Utilities	5-7%	Stable, low risk, high debt
Telecommunications	6-8%	Regulated, predictable cash flows
Consumer staples	7-9%	Stable demand, moderate risk
Manufacturing	8-10%	Cyclical, capital intensive
Retail	8-11%	Competitive, moderate risk
Technology	10-13%	Growth, higher risk, low debt
Biotechnology	12-15%	High risk, R&D intensive

Factors Affecting WACC

Market Conditions:

Rising interest rates → Higher WACC
Market volatility → Higher equity cost → Higher WACC
Economic recession → Risk premium increases → Higher WACC

Company-Specific:

Business risk (beta) → Higher risk → Higher WACC
Financial leverage → More debt initially lowers WACC, but too much increases risk
Credit rating → Better rating → Lower debt cost → Lower WACC
Size and stability → Larger, stable companies → Lower WACC

💡 WACC Sweet Spot

There's an optimal capital structure where WACC is minimised. Too little debt means missing tax benefits. Too much debt increases financial risk and raises both cost of debt and equity. Most companies target 30-50% debt ratio to balance benefits and risks.

⚠️ WACC Calculation Challenges

Market values vs book values: Use market values, not accounting book values
Estimating cost of equity: Beta and market premium are estimates, not certainties
Multiple debt instruments: Weight each by market value
Changing capital structure: WACC changes as debt/equity mix changes

🔢 Calculating WACC Step-by-Step

Example 1: NZ Manufacturing Company

Company XYZ Limited Capital Structure:

Step 1: Determine Market Values

Equity:

Shares outstanding: 10 million

Current share price: $8.50

Market value of equity (E): 10M × $8.50 = $85 million

Debt:

Bank loans: $30 million

Bonds outstanding: $20 million (at par)

Market value of debt (D): $50 million

Total value (V):

V = $85M + $50M = $135 million

Step 2: Calculate Weights

Weight of equity (E/V) = $85M / $135M = 63.0%

Weight of debt (D/V) = $50M / $135M = 37.0%

Step 3: Calculate Cost of Equity (CAPM)

Risk-free rate (NZ 10-year govt bonds): 4.2%

Market return (NZX50 expected): 9.5%

Company beta: 1.15

Re = Rf + β × (Rm - Rf)

Re = 4.2% + 1.15 × (9.5% - 4.2%)

Re = 4.2% + 6.10%

Re = 10.3%

Step 4: Calculate Cost of Debt

Total annual interest: $3.2 million

Total debt: $50 million

Rd = $3.2M / $50M

Rd = 6.4%

Step 5: Apply Tax Rate

Corporate tax rate: 28%

After-tax cost of debt = 6.4% × (1 - 0.28)

After-tax Rd = 4.61%

Step 6: Calculate WACC

WACC = (E/V × Re) + (D/V × Rd × (1 - Tc))

WACC = (0.630 × 10.3%) + (0.370 × 4.61%)

WACC = 6.49% + 1.71%

WACC = 8.20%

                Decision Rule: Company XYZ should only accept projects with expected returns above 8.20%. A project returning 10% would create value (10% - 8.20% = 1.80% excess return). A project returning 7% would destroy value.
            

Example 2: Comparing Capital Structures

Company evaluates different debt levels:

Current Structure (30% Debt):

Component	Value	Weight	Cost	Weighted
Equity	$70M	70%	11.0%	7.70%
Debt (after-tax)	$30M	30%	4.32%	1.30%
WACC	$100M	100%		9.00%

Proposed Structure (50% Debt):

Component	Value	Weight	Cost	Weighted
Equity	$50M	50%	12.5%	6.25%
Debt (after-tax)	$50M	50%	5.04%	2.52%
WACC	$100M	100%		8.77%

Note: Higher debt increases both cost of debt (6% → 7%) and cost of equity (11% → 12.5%) due to increased financial risk

But tax shield benefit outweighs the risk increase

WACC decreases from 9.00% to 8.77%

Lower WACC = Higher company value

Example 3: Project Evaluation Using WACC

Company considers $5M factory expansion:

Project Cash Flows:

Year	Cash Flow
0	($5,000,000)
1	$800,000
2	$1,200,000
3	$1,500,000
4	$1,500,000
5	$1,500,000

NPV Calculation (Discount at WACC = 8.2%):

NPV = -$5.0M + $800K/1.082 + $1.2M/1.082² + ... + $1.5M/1.082⁵

NPV = -$5.0M + $739K + $1,025K + $1,190K + $1,100K + $1,016K

NPV = -$5.0M + $5.07M

NPV = $70,000 (Positive!)

IRR Calculation:

IRR = 8.5%

IRR (8.5%) > WACC (8.2%)

Decision: ACCEPT PROJECT

Project creates $70,000 of value and returns 8.5%, which exceeds the 8.2% cost of capital.

Example 4: Valuing a Company Using WACC

DCF Valuation of ABC Limited:

Projected Free Cash Flows:

Year	FCF	PV Factor (9% WACC)	Present Value
1	$12.0M	0.917	$11.0M
2	$14.0M	0.842	$11.8M
3	$16.0M	0.772	$12.4M
4	$18.0M	0.708	$12.7M
5	$20.0M	0.650	$13.0M
Terminal	$250.0M	0.650	$162.5M

Enterprise Value:

Sum of PVs = $11.0M + $11.8M + $12.4M + $12.7M + $13.0M + $162.5M

Enterprise Value = $223.4M

Less: Net Debt = $40M

Equity Value = $183.4M

If 10M shares outstanding, fair value = $18.34 per share.

🌍 Real-World WACC Examples

NZ Electricity Company

Utility company evaluating grid upgrade investment

Capital Structure (Actual NZ Power Company):

Market cap (equity): $2,400M

Debt outstanding: $1,600M

Total value: $4,000M

Equity weight: 60%

Debt weight: 40%

Cost Calculations:

Cost of Equity (CAPM):

Risk-free rate: 4.0%

Beta: 0.75 (utilities are stable, low beta)

Market premium: 5.5%

Re = 4.0% + 0.75 × 5.5% = 8.1%

Cost of Debt:

Average interest rate: 5.2%

After-tax (28%): 5.2% × 0.72 = 3.74%

WACC:

WACC = (0.60 × 8.1%) + (0.40 × 3.74%)

WACC = 4.86% + 1.50%

WACC = 6.36%

Project Decision:

Grid upgrade cost: $250M

Expected return: 7.5%

7.5% > 6.36% WACC

Approve project (creates value)

                    Why Low WACC: Utilities have low business risk (regulated, stable demand), high debt capacity (predictable cash flows), and low beta (defensive stock). This allows cheap financing and low WACC of 6.36%, making many infrastructure projects viable.
                

Tech Startup Valuation

High-growth SaaS company raising capital

Capital Structure:

Recent funding round valuation: $80M

Equity: $80M (investors + founders)

Debt: $5M (equipment financing)

Equity weight: 94.1%

Debt weight: 5.9%

Cost Calculations:

Cost of Equity:

Risk-free: 4.0%

Beta: 1.8 (high volatility, high growth)

Market premium: 6.0%

Re = 4.0% + 1.8 × 6.0% = 14.8%

Cost of Debt:

Interest rate: 9.5% (risky borrower)

After-tax: 9.5% × 0.72 = 6.84%

WACC:

WACC = (0.941 × 14.8%) + (0.059 × 6.84%)

WACC = 13.93% + 0.40%

WACC = 14.33%

💡 High WACC for Startups

Tech startups have high WACC (14%+) due to: high business risk, volatile earnings, high beta, limited debt capacity, and investor return expectations. They must generate high returns to justify investment. Most VCs expect 25-30%+ returns to compensate for risk.

Retail Chain Expansion

NZ retail company planning store rollout

Capital Structure:

Market cap: $350M

Bank debt: $120M

Bonds: $80M

Total debt: $200M

Equity weight: 63.6%

Debt weight: 36.4%

Costs:

Component	Calculation	Result
Cost of Equity	4.2% + 1.3 × 5.8%	11.74%
Cost of Debt	6.8% (blended rate)	6.80%
After-tax Debt	6.8% × 0.72	4.90%

WACC Calculation:

WACC = (0.636 × 11.74%) + (0.364 × 4.90%)

WACC = 7.47% + 1.78%

WACC = 9.25%

Expansion Analysis:

New Store Investment	Expected Return	vs WACC	Decision
Auckland CBD	12.5%	+3.25%	✓ Approve
Hamilton	10.2%	+0.95%	✓ Approve
Invercargill	8.0%	-1.25%	✗ Reject

Result: Open 2 stores (Auckland, Hamilton). Invercargill store would destroy value with 8.0% return below 9.25% WACC.

Capital Structure Optimisation

Manufacturing company considers refinancing

Current Structure (25% Debt):

Item	Amount	Rate
Equity	$150M (75%)	10.5%
Debt (after-tax)	$50M (25%)	4.0%

Current WACC = (0.75 × 10.5%) + (0.25 × 4.0%)

= 8.88%

Proposed Structure (40% Debt):

Item	Amount	Rate
Equity	$120M (60%)	11.2%
Debt (after-tax)	$80M (40%)	4.5%

New WACC = (0.60 × 11.2%) + (0.40 × 4.5%)

= 8.52%

Impact:

WACC reduction: 8.88% → 8.52% (36 basis points)

On $200M enterprise value:

Annual savings: $200M × 0.36% = $720,000

Company value increase: ~$8-10M

                    Recommendation: Increase debt to 40% to lower WACC and increase firm value. Monitor financial flexibility and maintain investment-grade credit rating. Don't exceed 50% debt (risk becomes too high).
                

🎯 Test Your Knowledge

Complete this quiz on WACC

1. What does WACC represent?

The company's profit margin

The interest rate on debt

The average cost of all capital sources weighted by proportion

The return to shareholders only

2. Why is debt cost multiplied by (1 - Tax Rate) in WACC?

To punish companies for borrowing

Because interest is tax-deductible, reducing effective cost

To match accounting standards

It's a calculation error

3. Company has 60% equity (cost 12%), 40% debt (cost 6%, tax 28%). What is WACC?

9.0%

10.2%

8.93%

7.5%

4. WACC is used as the discount rate for:

DCF valuation and NPV project analysis

Calculating taxes

Determining dividend payments

Setting employee bonuses

5. A project with 10% IRR and company WACC of 8% should be:

Accepted (creates value)

Rejected (destroys value)

Neutral (no impact)

Needs more analysis

6. Which typically has the LOWEST WACC?

Tech startups

Biotech companies

Retail companies

Utility companies

7. Cost of equity is calculated using:

Dividend / Share Price

CAPM: Risk-free rate + Beta × Market Premium

Interest Rate + 2%

WACC - Cost of Debt

8. When calculating WACC, you should use:

Market values of debt and equity

Book values from balance sheet

Historical costs

Forecasted future values

9. Higher debt in capital structure generally:

Always increases WACC

Initially lowers WACC (tax benefit), but too much increases risk and WACC

Always decreases WACC

Has no effect on WACC

10. WACC is the minimum return a company must earn to:

Pay dividends

Avoid bankruptcy

Meet regulatory requirements

Satisfy both debt holders and equity investors

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