How do you calculate WACC and why does each component matter?

WACC (Weighted Average Cost of Capital) is the blended rate a company must earn on its investments to satisfy all capital providers — debt holders AND equity holders.

The formula:

WACC = (E/V) × Re + (D/V) × Rd × (1 - T)

Where:

• E = Market value of equity
• D = Market value of debt
• V = E + D (total firm value)
• Re = Cost of equity
• Rd = Cost of debt (pre-tax)
• T = Corporate tax rate

Why after-tax for debt?

Interest expense is tax-deductible. If Crestview Industries borrows at 6% and the tax rate is 25%, the after-tax cost is 6% × (1 - 0.25) = 4.5%. The government effectively subsidizes the interest cost.

Worked example:

Skyward Technologies has:

• Market value of equity: $800M (stock price × shares outstanding)
• Market value of debt: $200M
• Cost of equity (from CAPM): 11%
• Pre-tax cost of debt: 5%
• Tax rate: 30%

Critical points:

1. Use market values, not book values for the weights. Market values reflect current economic reality; book values may be outdated.

1. Cost of equity is usually estimated via CAPM: Re = Rf + β × (Rm - Rf). For Skyward: if Rf = 4%, β = 1.2, and market premium = 5.83%, then Re = 4% + 1.2(5.83%) ≈ 11%.

1. WACC is the hurdle rate for new projects with similar risk to the company. If a project earns less than 9.50%, it destroys value.

1. Preferred stock: If the company has preferred equity, add a third component: (P/V) × Rp, where Rp = preferred dividend / preferred stock price.

1. WACC decreases as you add more (cheap) debt — up to a point. Beyond that, financial distress risk increases the cost of both debt and equity.

Practice WACC calculations in our CFA Level I question bank.