What is WACC?

A company is funded by two kinds of investor: shareholders (equity) and lenders (debt). Each expects a return. WACC blends those two required returns into a single number — the overall rate the company must earn on its investments to satisfy everyone who funded it. It's the hurdle every project has to clear, and the discount rate in a DCF.

The formula

WACC weights the cost of each funding source by how much of it the company uses:

• WACC = (E/V × cost of equity) + (D/V × cost of debt × (1 − tax rate))

Here E is equity, D is debt, and V is the total (E + D). In plain terms: take what shareholders require and what lenders require, and blend them in proportion to how much of each the company relies on.

The cost of equity

The cost of equity is the return shareholders demand — and it's the harder piece to pin down, since shareholders aren't promised anything. It's usually estimated with the Capital Asset Pricing Model: the risk-free rate plus beta times the equity risk premium. The higher a stock's beta (its sensitivity to the market), the higher the return shareholders require to hold it.

The tax shield on debt

Notice the "(1 − tax rate)" attached to the cost of debt. That's the tax shield: because interest payments are tax-deductible, debt costs the company less than the headline interest rate suggests. This is one reason debt is typically cheaper than equity — it's tax-advantaged, and it's also a safer, senior claim for the investor providing it.

Why it matters

WACC is the hurdle rate. A project expected to return more than WACC creates value; one returning less destroys it. And because WACC is the discount rate in a DCF, small changes in it swing valuations significantly — nudge the WACC up and the value of all those future cash flows falls. Getting it roughly right is central to any serious valuation.