What is WACC?
WACC, the weighted average cost of capital, is the blended rate a company pays to finance itself across both equity and debt. It weights each source by how much of the total capital it makes up.
It represents the minimum return the business must earn to satisfy everyone funding it. Earn less than WACC and the company destroys value; earn more and it creates value.
The WACC formula.
WACC = (equity over total capital times cost of equity) plus (debt over total capital times after-tax cost of debt). In symbols, (E/V x Re) + (D/V x Rd x (1 minus the tax rate)).
The tax adjustment on debt is the subtle part. Because interest is tax-deductible, the effective cost of debt is lower than its stated rate, which is why debt often looks cheaper than equity.
A worked example.
A company funded by 600,000 of equity at a 10% cost and 400,000 of debt at a 5% cost, taxed at 25%, has a WACC of (0.6 x 10) plus (0.4 x 5 x 0.75), which is 6 plus 1.5, or 7.5%.
What is WACC used for?
It plays two central roles: the discount rate in a valuation, and the hurdle rate an investment must beat to be worth making. A project whose return exceeds WACC creates value; one below it does not.
WACC is the bar that returns get measured against. Reading it next to the burn the return must beat connects the cost of capital to how efficiently cash is being spent.
How it is used in valuation.
WACC discounts future cash flows to present value in a DCF, and it sets the threshold for IRR. A higher WACC lowers the present value of future cash and raises the bar a project's IRR has to clear.
For an operating company, sustained returns above the cost of capital come from efficient growth, the kind that does not consume cash to produce, which is part of the case for a channel that compounds over time.