What WACC actually is
WACC is the blended cost of all the capital financing a business — the rate the company has to earn on its assets to keep every capital provider whole. It's the discount rate that goes into a DCF, the hurdle rate in capital budgeting, and the implicit benchmark in any "is this deal worth doing" question.
Two ingredients:
- Cost of equity — what equity investors require to bear the risk of the business. Computed from CAPM.
- After-tax cost of debt — what lenders charge, adjusted for the tax deductibility of interest. (Debt is cheaper than equity in part because interest is tax-deductible.)
Blend them by capital structure weights and you have WACC:
WACC = Ke × (E/V) + Kd × (1 − t) × (D/V)
where Ke is cost of equity, Kd is pre-tax cost of debt, t is the marginal tax rate, and E/V and D/V are equity and debt weights in the total capital structure.
CAPM cost of equity, in one equation
The Capital Asset Pricing Model computes cost of equity as:
Ke = Rf + β × ERP
Three inputs, each contentious in its own way:
Risk-free rate (Rf)
Conventionally the 10-year US Treasury yield. The logic: equity investors won't accept a return below the risk-free alternative, so cost of equity is anchored on Treasuries. In practice the 10Y can swing 200-300 basis points across a cycle, which moves WACC by enough to materially change enterprise value. Use a current-year value, not a long-run average.
Equity risk premium (ERP)
The excess return equity has historically earned over Treasuries. The Damodaran spreadsheets — the de-facto industry reference — publish updated ERP estimates regularly. As of recent years, ERP sits in the 4.5%-6.5% range for the US, depending on method. Pick a single value and document it. Don't use 4% in one analysis and 7% in another; the inconsistency will get flagged in diligence.
Beta (β)
The sensitivity of the stock's returns to the market's returns. A beta of 1.0 means the stock moves with the market; 1.5 means it amplifies market moves; 0.5 means it dampens them. For a public company you can pull regression beta from Bloomberg/CapIQ. For a private company you take comparable public companies' betas, unlever each by their actual capital structure, average them, and relever by the target's capital structure. Skipping the unlever-relever is a common error.
After-tax cost of debt
Cost of debt before tax is just the yield to maturity on the company's outstanding debt — or, for a fresh deal, the rate you'd expect to refinance at today (typically SOFR + a spread for term loans, or a fixed coupon for bonds).
The tax adjustment matters. Interest is tax-deductible, so the true economic cost to the company is the after-tax rate:
Kd_after_tax = Kd × (1 − t)
A 7% coupon at a 25% tax rate is a 5.25% after-tax cost. The tax shield is one of the main reasons leverage adds value in an LBO — shifting capital from equity to debt lowers WACC, raises enterprise value, and (mathematically) increases equity returns.
Where WACC calculations break
1. Book weights instead of market weights
The weights in the WACC formula should be market values of debt and equity, not book values. A company with $100M of book equity but $400M of market cap and $50M of debt has equity weight ≈ 89% (400/450), not 67% (100/150). Using book weights systematically over-counts debt in the WACC and under-states the discount rate.
2. Forgetting to unlever beta
A levered company's observed beta includes the effect of its capital structure. To use comp betas for a target with a different leverage profile, unlever each comp by its actual D/E ratio, average the unlevered betas, and relever by the target's ratio. The Hamada equation:
β_levered = β_unlevered × [1 + (1 − t) × D/E]
Solve for unlevered, average, then re-solve for levered using the target's D/E.
3. Using a single WACC for a multi-stage business
A growing business's WACC isn't constant — early-stage risk and limited debt capacity mean a high cost of capital; maturity brings lower beta, more debt, lower WACC. For DCFs of businesses still in growth-to-maturity transition, model WACC by phase rather than a single weighted average.
When to revisit your WACC
WACC isn't a one-and-done input. Revisit it any time:
- The risk-free rate has moved more than 100 bps
- The target's capital structure has changed materially (refi, dividend recap, large equity raise)
- Comp set has shifted (a comparable was taken private, or new ones IPO'd)
- You're comparing this deal against another with a different cost of capital — calibrate them on a common-rate basis