The weighted average cost of capital (WACC): What is it and how to calculate it?
The cost of capital is used for investment decisions: it is the rate at which cash flows are discounted in the NPV calculation or the rate at which IRR is compared.
In other words, it is the minimum return rate that investments must generate for a company to meet the shareholders’ requirements (cost of equity) and creditors’ profitability requirements (cost of debt). The cost of capital represents the company’s net financing.
WACC formula
WACC = VDebt / (Ve + VDebt) x CoD x (1 - Tax) + Ve / (Ve + VDebt) x CoE
Where:
VDebt = Value of the debt
Ve = Value of equity
CoD = Cost of debt (interest rate)
CoE = Cost of equity (required return by investors)
Tax = Corporate taxes (since interest on debt is tax-deductible)
Focus on the cost of debt
The cost of debt corresponds to the return expected by lenders, or in other words, the interest rate. A company’s cost of debt should be based on the interest rate of the debt raised today, not on past debts. If the company has a current credit rating, that provides an ideal reference. If not, it may be necessary to estimate the current rate using the most recent debt issued. For listed companies, the interest rate can often be found in the annual report (10-K).
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Focus on the cost of equity (CAPM)
The cost of equity is the return expected by shareholders. Since this rate is not directly observable, it must be estimated using an asset pricing model. The most commonly used model in investment banking is the CAPM (Capital Asset Pricing Model).
In a rational environment, where it is assumed that all individuals make rational choices, it is considered that there is always a risk-free investment. This investment might have a return of 0% or even be negative, but it is assumed that it would not be appealing to anyone. Therefore, a risk-free investment with a minimal return is considered to exist. In France, Treasury bonds are an example of a nearly risk-free investment, with a return of 3.44% in January 2025 (source: Agence France Trésor).
CAPM postulates that, if such an investment exists, no rational investor would choose another investment offering the same return but with risk. The CAPM goes further by asserting that an investor would accept increased risk in a given investment only if it offers an equivalent possibility of receiving a higher return.
Thus, we have:
Cost of equity = Rf + ß x MRP
Where:
Rf = Risk-free rate
ß = Represents the systematic risk of a company’s equity
MRP = Market risk premium = Rf - Rm (Risk-free rate - market risk)
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Focus on Beta
Beta represents the systematic risk of a company’s equity. It is a correlation coefficient that measures the extent to which a company’s historical returns move in relation to a benchmark index, such as the S&P 500.
If a company has a beta of 1, it means it is perfectly correlated with the S&P 500.
If the S&P 500 returns 5%, the company will also return 5%.
If the beta is 0.5, the company should return 2.5%.
A company’s beta is calculated by comparing its historical returns over a given period (10, 20, or 30 years) to the benchmark index.
A high beta suggests greater volatility (and therefore higher risk), which implies a higher discount rate and, all else being equal, a lower valuation.
- High Beta: Cyclical industries like automotive, semiconductors, or construction, which depend on economic growth
- Low Beta: Non-cyclical sectors like consumer goods (hygiene, food), healthcare, or utilities, which remain stable even during recessions
- Negative Beta: Gold and precious metals
Example:
Consider a company with negative debt of 2 and equity of 9. The cost of equity is 7%, and the net cash provides a 2% return after taxes. Therefore, the cost of capital is 8.4%:
WACC = 7% x 9 / (9 - 2) + 2% x (-2) / (9 - 2)
To satisfy the shareholder’s required return, the company must invest in projects with a return of at least 8.4%.
