Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital, or WACC, is a company's average cost of capital. It combines the cost of equity and debt, weighted by their respective shares. In valuation, it serves as the discount rate used to discount future cash flows. The formula is: cost of equity multiplied by the equity share of total capital, plus cost of debt multiplied by one minus the tax rate and by the debt share.

Including tax reflects the deductibility of interest as a business expense. The target capital structure at market values, not the current balance sheet, should always be used for the weighting, because valuation assumes a steady state and existing financing is regularly repaid on a change of ownership anyway. A methodological particularity follows: the weights depend on the market value of equity, which is itself the result of the valuation, so either an iterative calculation is used or a sector-typical target structure assumed.

A common fallacy is the assumption that more debt lowers the cost of capital without limit. In fact both the cost of equity and the cost of debt rise as leverage increases, so the benefit is bounded. Because small changes produce large effects on value, every valuation should include a sensitivity analysis on this rate.

The cost of equity is usually derived from the capital asset pricing model, that is the risk-free rate plus beta times the market risk premium, supplemented for smaller companies by premiums for size and lack of marketability. The German Institute of Public Auditors publishes recommendations on the market risk premium that are widely used in German valuation practice. The chosen range has to be reasoned in the report, not simply asserted. The rate is used as the discount factor in the discounted cash flow method and at the same time as the benchmark for return measures such as return on invested capital.