Corporate finance / cost of capital

Weighted average cost of capital

Blend the cost of equity and the after-tax cost of debt on market-value weights to get the hurdle rate a company should use for average-risk projects. The CAPM build-up and the tax shield are shown separately so each assumption is auditable.

Capital base$1,000Equity beta1.10Shield value0.46%

WACC

7.89%

Blended after-tax cost of capital

Cost of equity Kₑ

10.25%

4.20% risk-free + 1.10 × 5.50% premium

After-tax cost of debt

4.35%

5.50% pre-tax × (1 − 21.0%)

Debt weight D/V

40.0%

Leverage of 0.67× debt-to-equity

Capital structure and cost components

Each source of capital with its weight, its cost, and its contribution to the blended rate.

$1,000 capital

Capital structure and cost components
Component	Weight	Cost	Contribution
Equity (CAPM)	60.00%	10.25%	6.15%
Debt (after tax)	40.00%	4.35%	1.74%
Debt (pre-tax)	40.00%	5.50%	—
Tax shield benefit	—	21.0%	0.46%
WACC	100.00%	—	7.89%

Weights use market values, not book values. Using book equity is the most common way a WACC calculation goes wrong.

Weights vs cost contributions

How much of the capital each source provides, and how much of the WACC it drives.

WACC vs leverage

Blended cost of capital as the debt share rises, holding the component costs fixed.

Canonical equations

The exact relationships implemented by this engine.

Kₑ = r_f + β·ERP · CAPM; beta scales the equity risk premium

K_d(1 − T) · interest is tax-deductible, so debt is cheaper than its coupon

WACC = (E/V)Kₑ + (D/V)K_d(1−T) · market-value weights, V = E + D

NPV = Σ CFₜ/(1+WACC)ᵗ − C₀ · the hurdle rate for projects of average risk

Show model notation and computationOpen the symbolic form, the variable definitions, and the step-by-step derivation when you need the detail.

A clear path from inputs to results.

WACC is the blended after-tax cost of every dollar of long-term capital a company uses. It is the minimum return a new project must earn to leave shareholders no worse off, which is why it doubles as the discount rate in most corporate valuations.

Step-by-step methodWorked exampleAssumptions explained

How to use

Enter the market value of equity — market capitalisation, not book equity.

Enter the market value of debt, ideally at market rather than face value.

Set the risk-free rate, typically a long-dated government bond yield.

Add the equity risk premium and the company’s equity beta to build the cost of equity through CAPM.

Enter the pre-tax cost of debt and the marginal tax rate so the interest tax shield is applied.

Read the WACC, then check the leverage sensitivity — the blend is not flat in capital structure.

The formula

K_e = r_f + \beta \cdot \mathrm{ERP}, \qquad \mathrm{WACC} = \frac{E}{V}K_e + \frac{D}{V}K_d(1-T), \qquad V = E + D

Reference: Modigliani & Miller (1958, 1963) — the after-tax WACC follows the 1963 tax correction; Damodaran, "Applied Corporate Finance", ch. 7–8.

Worked example

60/40 capital structure, 1.1 beta (default inputs)

Inputs

Market value of equity $600m, debt $400m.
Risk-free rate 4.2%, equity risk premium 5.5%, beta 1.1.
Pre-tax cost of debt 5.5%, marginal tax rate 21%.

Calculation path

1
Capital weights: E/V = 60%, D/V = 40%.
2
Cost of equity: 4.2% + 1.1 × 5.5% = 10.25%.
3
After-tax cost of debt: 5.5% × (1 − 0.21) = 4.345%.
4
Blend: 0.60 × 10.25% + 0.40 × 4.345% = 7.888%.

Result

WACC 7.89% · cost of equity 10.25% · after-tax cost of debt 4.345% · debt weight 40%.

Interpreting the result

The 7.89% WACC is the hurdle rate for projects of average risk. Debt looks cheap at 5.5%, but its after-tax cost of 4.345% is only cheap because the government absorbs part of the interest through the tax shield. As leverage rises the WACC falls at first and then rises as equity holders demand compensation for financial distress — the sensitivity chart shows the first half of that curve, holding component costs fixed.

Assumptions & limitations

Weights use market values. Book-value weights are the most common source of error in a WACC calculation.

The tax rate should be the marginal rate, not the effective rate from the last annual report.

Beta is assumed stable and measured against a broad market index over a reasonable window.

The capital structure is assumed constant. A company targeting a different leverage needs target weights.

Only long-term debt and equity are counted; short-term operating liabilities are excluded.

Frequently asked questions

Why use market values rather than book values?

Because the cost of capital reflects what investors require today on the capital they have actually committed at current prices. Book equity is a historical accounting residual and can be a fraction of market value, which would badly distort the weights.

Which beta should I use?

A regression beta against a broad index over two to five years of monthly or weekly returns, ideally adjusted toward 1.0. For a divisional project, use peer betas unlevered and relevered to the target structure.

Is WACC the right discount rate for every project?

Only for projects with the same risk as the existing business. A software division inside an industrial group needs its own beta and its own WACC, otherwise high-risk ventures get discounted at too low a rate.

What if the company has no debt?

Then WACC equals the cost of equity. Set the debt value to zero and the blend collapses to the CAPM figure. Unlevered companies still have a cost of capital — it is just all equity.

Why is the tax rate applied only to debt?

Because interest is tax-deductible while dividends are not. That asymmetry is the entire source of the tax shield and a large part of why capital structure affects WACC at all.

What happens to WACC as leverage increases?

At low leverage, adding debt lowers WACC because debt is cheaper and tax-advantaged. Beyond a point, equity beta rises and distress costs appear, pushing WACC back up. This engine holds component costs fixed, so it shows only the mechanical first half.