Weighted average cost of capital (WACC)

What WACC is

The weighted average cost of capital is the average return a company must pay its investors, weighted by how much of each type of finance it uses. It is often used as the discount rate for investment appraisal.

Cost of equity

Dividend growth model:

Ke = D0 × (1 + g) ÷ P0 + g

where D0 is the dividend just paid, g is the expected growth rate and P0 is the ex-dividend share price.

Capital asset pricing model (CAPM):

Ke = Rf + β × (Rm − Rf)

where Rf is the risk-free rate, Rm is the market return and β measures the share's systematic risk.

Cost of debt

Interest is tax deductible, so debt is included at its after-tax cost.

• Irredeemable debt: Kd = interest × (1 − tax rate) ÷ market value of the debt.
• Redeemable debt: find the internal rate of return of the after-tax cash flows: the market value now, after-tax interest each year and the redemption value at the end.
• Bank loans: use the interest rate × (1 − tax rate).

Worked example

A company's equity has a market value of $600 million and a cost of 12%. Its debt has a market value of $400 million and an after-tax cost of 5%.

• Weight of equity = 600 ÷ 1,000 = 0.6
• Weight of debt = 400 ÷ 1,000 = 0.4
• WACC = (0.6 × 12%) + (0.4 × 5%) = 7.2% + 2.0% = 9.2%

Common mistakes

• Using book values when market values are given.
• Forgetting to take tax off the cost of debt.
• Using the cum-dividend share price in the dividend growth model.
• Using WACC for a project with very different risk.

Where this leads

ACCA AFM builds on WACC with project-specific discount rates, using asset and equity betas.