WACC

What it means

WACC is the weighted average cost of capital: the cost of debt (interest after the tax effect) and the cost of equity (the return owners require), weighted by their shares.

Debt is cheaper because interest is deductible and the lender carries less risk. So as leverage rises WACC first falls and then, past a safe level, climbs again.

The weights should properly come from market values of capital, not from book amounts. Equity on the balance sheet shows what the owners once put in and what the company has not distributed, not what their stake would sell for today. In a healthy company the market value of equity is higher, so WACC sits closer to the cost of equity than the balance sheet would suggest.

How it works in practice

It serves as the discount rate in NPV and the hurdle for IRR. A project returning less than WACC adds no value, however healthy it looks in accounting profit.

In an income-based business valuation WACC is one of the two most sensitive inputs. A single percentage point moves the value by tens of percent.

A company is considering entering a new market alongside its existing production. That project is riskier than the usual business, and judging it by the company-wide WACC would flatter it. In a feasibility study riskier projects are therefore discounted at a higher rate that reflects their own risk, not the average of the whole firm.

What to watch out for

Small companies often count only the interest on a loan and ignore the cost of equity. The result is a profit that does not even meet the owner’s own expectation.

The plan projects cash flows in constant prices, without inflation, but discounts them at a nominal WACC that already contains inflation. The project comes out worth less than it is and a good investment is turned down. The opposite mistake, nominal flows with a real rate, inflates the value. Flows and rate must be stated in the same prices.