What is weighted average cost of capital (WACC)?

Explanation of weighted average cost of capital (WACC)

WACC represents the overall cost of financing a business through a mix of equity and debt. It is widely used in corporate finance, business valuation, investment appraisal and financial modelling.

The calculation combines the cost of equity, which reflects the return expected by shareholders, and the cost of debt, which reflects interest payable to lenders. Each component is weighted according to its proportion within the company’s capital structure. The cost of debt is typically adjusted for Corporation Tax, as interest is generally deductible for UK tax purposes.

WACC is commonly used as a discount rate when valuing future cash flows, including in discounted cash flow models and impairment testing under UK-adopted IFRS and FRS 102. It provides a benchmark rate against which investment returns may be assessed and supports decision-making in mergers, acquisitions and capital investment.

Key characteristics of weighted average cost of capital (WACC)

Key characteristics of weighted average cost of capital (WACC) include the following:

• It combines the cost of equity and the cost of debt into a single blended rate.
• It reflects the company’s target or actual capital structure.
• It incorporates market-based expectations of risk and return.
• It typically includes a tax adjustment to reflect the deductibility of interest.
• It is commonly used as a discount rate in valuation and impairment assessments.

How weighted average cost of capital (WACC) works

The calculation of WACC typically involves the following steps:

1. Determine the proportion of equity and debt within the company’s capital structure.
2. Estimate the cost of equity, often using a model such as the Capital Asset Pricing Model.
3. Identify the cost of debt based on current borrowing rates.
4. Adjust the cost of debt to reflect the tax effect where relevant.
5. Apply the weightings to each component and calculate the combined average rate.

The resulting percentage represents the average required return across all sources of finance.

Common misconceptions about weighted average cost of capital (WACC)

WACC does not represent the interest rate on a single loan.
WACC is not the same as the return achieved on a specific investment.
WACC does not remain constant over time, as capital structure and market conditions can change.

Questions about WACC

How is WACC different from the cost of equity?

The cost of equity reflects the return expected by shareholders only. WACC combines the cost of equity and the cost of debt, weighted by their relative proportions in the company’s financing structure.

Why is debt adjusted for tax in WACC?

Interest on debt is generally deductible for UK corporation tax purposes. As a result, the effective cost of debt is reduced by the tax relief available, which is reflected in the WACC calculation.

When is WACC used?

WACC is commonly used in business valuations, investment appraisals, discounted cash flow modelling and impairment testing under relevant accounting standards.

Does every company have the same WACC?

WACC varies between companies depending on their capital structure, risk profile, industry sector and prevailing market conditions.