Also: WACC, cost of capital, hurdle rate, cost of equity, after-tax cost of debt
WACC blends the returns a company's lenders and shareholders require, each weighted by its share of the capital structure, with debt counted after tax; it is the rate for discounting firm-level cash flows and the usual benchmark for new investment.
Our take. One company-wide WACC applied to every project quietly subsidises the risky ones and penalises the safe ones; the rate should follow the risk of the project, not the average of the firm that happens to own it. CFA Institute's own material concedes there is no single right method for estimating the inputs, so a figure quoted to two decimal places claims more precision than exists.
Three ingredients go in. The cost of debt is what lenders require, reduced by the tax saving on interest where interest is deductible. The cost of equity is what shareholders require for owning the business, commonly estimated with the capital asset pricing model: a risk-free rate plus a premium scaled by how strongly the company's shares move with the market. The weights are each source's share of total capital, taken at market values where they exist, because new capital would be raised at today's prices rather than historical book amounts. Multiply each cost by its weight and add the products.
Estimates that move the answer
Risk-free rate: which government bond, and which maturity, should match the horizon of the cash flows being discounted.
Equity risk premium: historical and forward-looking estimates differ, and that choice alone can shift the result noticeably.
Beta: observed for listed peers, then unlevered and relevered to the target structure, a step where CFA Institute research digests document recurring pitfalls.
Weights: current market proportions or the structure the company intends to hold; the two can be far apart.
Borrowing, and the two jobs the rate does
Because debt is cheaper than equity after tax, adding borrowing appears to lower WACC. It does so only until the extra leverage makes lenders and shareholders both demand more, which is the capital structure question at the centre of corporate finance and valuation. In practice the figure does two jobs: it is the denominator in a firm-level discounted cash flow model, and it is the hurdle a project's net present value is measured against. Both jobs inherit every judgement made above, so a valuation report should state its inputs rather than just the blended number.
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