Cost of Capital (WACC)

Every dollar a company invests in itself had to come from somewhere. Broadly, there are two sources: borrowing (debt) or money contributed by owners (equity). Neither is free. Lenders charge interest — that's the cost of debt. Shareholders don't charge an explicit interest rate, but per Risk & Return, they still expect compensation for the risk of owning a business whose value can rise or fall, and who only get paid after lenders do if the company runs into trouble — that expected return is the cost of equity, and it's consistently higher than the cost of debt, precisely because equity holders bear more risk.

Every investment a company makes — a new factory, an acquisition, an entire project evaluated with Net Present Value — has to clear a bar: it needs to earn enough to compensate both the lenders and the shareholders whose money is funding it. If a company is financed by a mix of debt and equity, that bar isn't just the cost of debt or just the cost of equity — it has to be a blend of both, weighted by how much of the company's financing actually comes from each source. That blended rate is WACC, and it's exactly the discount rate used as r in Net Present Value and in DCF Valuation: too low a WACC makes a bad investment look acceptable, too high a WACC makes a good one look unacceptable.

There's one more wrinkle: interest paid on debt is tax deductible — it reduces the company's taxable income, so the government effectively absorbs part of the interest cost. Dividend payments to shareholders get no such deduction; they're paid out of profit that's already been taxed. That's why the cost of debt gets adjusted downward for taxes in the WACC formula, while the cost of equity doesn't — debt has a genuine, built-in tax advantage that equity doesn't share.

Cost of debt is usually easy to observe — it's close to the interest rate a company actually pays its lenders. Cost of equity is harder, since shareholders never state a required rate the way a lender states an interest rate. The most common way to estimate it is the Capital Asset Pricing Model (CAPM): start from a safe baseline (the risk-free rate, roughly what a government bond pays), add the extra return the stock market as a whole is expected to demand over that baseline (the market risk premium), scaled by how much more or less this particular stock moves than the market as a whole (its beta). A stock with a beta of 1.0 is exactly as volatile as the market and gets exactly the market risk premium; a riskier stock with a beta of 1.5 gets 1.5× that premium on top of the risk-free rate.

WACC also answers a question that comes up in Capital Budgeting Decision Rules: what rate should count as the "required rate of return," or hurdle rate, a project has to clear? For a company evaluating its own investments, the hurdle rate is usually its own WACC — a project that doesn't earn at least enough to cover WACC isn't even earning back the cost of the money funding it, regardless of how good it might look on any other measure.

Cost of equity, via CAPM:

Re = Rf + β × (Rm − Rf)

• Rf — the risk-free rate
• β (beta) — how much the stock moves relative to the overall market
• Rm — the expected return of the overall market; (Rm − Rf) is the market risk premium

Once cost of equity is known, it feeds into WACC:

WACC = (E / V) × Re + (D / V) × Rd × (1 − Tax rate)

• E — market value of equity; D — market value of debt; V — total (E + D)
• Rd — cost of debt, the interest rate lenders charge, before tax

(E / V) and (D / V) are the weights — the share of total financing that comes from each source — and they always add up to 100%.

A company is financed with $6 million of equity and $4 million of debt — $10 million in total. The risk-free rate is 3%, the expected market return is 12%, and this stock's beta is 1.0 (it moves in line with the market). The company can borrow at a 6% interest rate, and it faces a 25% tax rate.

Cost of equity (CAPM): Re = 3% + 1.0 × (12% − 3%) = 12%

Weight of equity: $6M / $10M = 60%
Weight of debt:   $4M / $10M = 40%

After-tax cost of debt: 6% × (1 − 25%) = 4.5%

WACC = (60% × 12%) + (40% × 4.5%)
     = 7.2% + 1.8%
     = 9.0%

This company needs to earn at least 9% on a new investment — its hurdle rate for Capital Budgeting Decision Rules — to satisfy both its lenders and its shareholders. Recall the DCF Valuation worked example, which discounted cash flows at a 12% rate "its WACC" without showing where that number came from — this is exactly the calculation that would produce a number like that, for a company with a different equity/debt mix or higher-risk shareholders demanding a bigger return.