WACC — Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is the blended cost of every capital source a firm uses — equity and debt — weighted by their market values. The formula is WACC = (E/V) × Re + (D/V) × Rd × (1 - T), where E is the market value of equity, D the market value of debt, V = E + D total financing, Re the cost of equity, Rd the cost of debt and T the corporate tax rate. The (1 - T) term captures the tax shield of debt — interest is deductible, so the after-tax cost of debt is lower than its nominal rate. The cost of equity Re is typically estimated with the Capital Asset Pricing Model (CAPM) as Re = Rf + β × (Rm - Rf). WACC serves as the discount rate in NPV calculations and as the hurdle rate in IRR decisions: if IRR > WACC the project earns above its cost of capital and creates value. An SMB finance manager uses WACC as the benchmark for equipment purchases, plant expansion, new product lines and acquisition decisions. As leverage (D/V) rises, WACC first falls (cheap debt benefit) then rises (bankruptcy risk lifts the cost of equity); this U-shape is at the heart of the optimal capital structure debate. The theoretical foundation was laid by Modigliani & Miller 1958 ('The Cost of Capital, Corporation Finance and the Theory of Investment') and refined by Miller & Modigliani 1963 with the tax correction, formalizing how debt can raise firm value through the tax shield.