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The cost of capital and WACC

A company's cost of capital is the return its lenders and shareholders require, blended into one weighted-average rate that becomes the hurdle every new investment must clear.

Video lesson · 6 min. Watch it first, then use the text below to go deeper.

In short

The cost of capital is investors' required return; it is set in financial markets, not chosen by management.
Debt is cheaper than equity: lenders hold a priority, fixed claim (sometimes secured), shareholders a residual one; interest is often tax deductible, dividends are not.
WACC = after-tax cost of debt × weight of debt + cost of equity × weight of equity (plus any other sources such as preferred stock).
Use market value weights (investors' opportunity cost) or management's target weights; book values reflect history.
WACC is the discount rate *r* in NPV and the hurdle rate for IRR, adjusted for project-specific risk.
Management's two capital structure aims: the lowest WACC and, where economical, matching the horizon of financing to the assets.

Why debt costs less than equity

A company raises money from two kinds of investors, and each expects a return for the risk it carries. That required return, seen from the company's side, is its cost of capital. If the company cannot find projects that beat it, the value-creating move is to hand the money back so investors can earn their required return elsewhere.

Lenders take less risk than shareholders. Their claim is fixed, it ranks ahead of shareholders, and it may be secured by an asset that passes to them on default. Shareholders hold a residual claim with no end date and no promised payment. Less risk means a lower required return, so the cost of debt is below the cost of equity.

Taxes widen the gap. In many jurisdictions interest is deductible from taxable income, so each unit of interest costs the company only $(1 - t)$ after tax. Dividends and other payments to shareholders are not deductible.

Both costs are prices set by investors in the market. Management can influence them through its decisions, but it cannot simply declare a lower cost of debt or equity.

Estimating each ingredient

Cost of debt. Start with the yield on the company's existing unsecured loans and bonds. For a forward-looking figure, the rate at which similar companies have recently borrowed is a good guide to what new debt would cost. Where interest is deductible, multiply by $(1 - t)$ , using the marginal tax rate, to get the after-tax cost of debt.

Cost of equity. There is no contractual rate to observe, so it must be estimated. A rough starting point is the long-run return on broad equity markets (around 10% a year in a long US history), then adjusted for company-specific risk such as how stable its cash flows are. Later readings develop proper models.

Weights. Use either the market values of debt and equity or management's target weights (often stated in book values). Market values are preferred because investors' opportunity cost depends on what the securities are worth today, not on the historical prices recorded on the balance sheet.

Other sources. If the company also uses financing with its own risk and return, such as preferred stock or non-controlling interests, add its weighted (after-tax) cost as an extra term.

Book versus market value weights (example 2: Halden Shipping)
	Book value	Market value
Debt	EUR 300m	EUR 300m
Equity	EUR 200m	25m shares × EUR 18 = EUR 450m
Weight of debt	60%	40%
WACC (rd 5%, t 25%, re 10%)	6.25%	7.50%

Halden's shares trade far above book value, so on market values equity is 60% of capital, not 40%. Using book weights here would understate WACC (6.25% instead of 7.50%).

Putting it together and using it

WACC blends the component costs into one rate. Each cost is multiplied by its share of total capital, with the cost of debt taken after tax. For an all-equity company the weight of debt is zero, so WACC simply equals the cost of equity.

WACC, adjusted for any risk specific to the project, is the discount rate *r* used in NPV analysis and the hurdle rate for IRR. A project returning more than WACC adds value; one returning less destroys it.

This gives management its first capital structure objective: choose the mix of debt and equity that produces the lowest WACC, because a lower required return raises the NPV of every project. The second objective is to match the horizon of the financing to the assets where possible and economical, for example long-term debt for long-lived plant.

Shareholder value therefore grows from two directions: a higher return on investment and a capital structure that delivers a lower WACC.

Norrvik AB (example 1): 35% debt at 6% × (1 − 0.22) contributes 1.64 points and 65% equity at 11% contributes 7.15 points, for a WACC of 8.79%.

Formulas

Weighted-average cost of capital: $\text{WACC} = w_d\, r_d (1 - t) + w_e\, r_e$
w = weight of each source in total capital (market or target), r_d = pre-tax cost of debt, t = marginal tax rate, r_e = cost of equity. Add w_p r_p for preferred stock or other sources.
After-tax cost of debt: $r_d^{\text{after-tax}} = r_d (1 - t)$
Only where interest is tax deductible. Dividends get no such adjustment.

Worked examples

Example 1 A basic WACC

Norrvik AB is financed 35% with debt and 65% with equity and intends to keep that mix. Lenders require 6% before tax, shareholders require 11%, and the marginal tax rate is 22%. What is Norrvik's WACC?

Example 2 Book or market weights?

Halden Shipping's balance sheet shows debt of EUR 300m (worth about the same in the market) and equity of EUR 200m. It has 25m shares trading at EUR 18. Its pre-tax cost of debt is 5%, its cost of equity 10% and its tax rate 25%. Compute WACC with book and with market weights. Which is more appropriate?

Example 3 Adding preferred stock and interpreting the result

Castellana SA's capital is 30% debt, 10% preferred stock and 60% common equity. Pre-tax cost of debt is 7%, cost of preferred 8%, cost of equity 12%, tax rate 30%. A project with the company's average risk has an IRR of 9.2%. What is WACC, and should Castellana accept the project?

On the exam

Expect a direct WACC calculation, often with a twist: switching from book to market weights, adding preferred stock, or asking how WACC moves when the tax rate or a component cost changes.

Applying $(1 - t)$ to the cost of equity or to the whole WACC. Only interest is deductible.
Using book values of equity when market values are available and differ.
Thinking management sets the cost of debt or equity. Investors set them in the market.
Forgetting that a higher tax rate lowers the after-tax cost of debt and therefore WACC.

Check yourself

Q1A company has 40% debt and 60% equity, a pre-tax cost of debt of 5%, a cost of equity of 9% and a 20% tax rate. Its WACC is closest to:
Q2The cost of equity is higher than the cost of debt mainly because:
Q3When computing WACC, the weights most commonly used are based on:
Q4A firm has 25% debt at a pre-tax cost of 8% and 75% equity at 12%. If its tax rate rises from 20% to 30%, its WACC changes by approximately:
Q5A firm has debt of EUR 200m (book and market) and book equity of EUR 150m. Its 30m shares trade at EUR 10. The market-value weight of debt is closest to:
Q6Which is least likely a management objective when choosing a capital structure?

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