DCF

WACC, explained

6 min read · updated July 2, 2026

Every dollar of capital a company uses has a price. Lenders want interest. Equity holders want a return that pays them for the risk of owning the stock. The weighted average cost of capital (WACC) is just those two prices blended by how much of each the company uses. That's it.

Why should you care before you can compute it? Because WACC is the rate you discount cash flows at in a DCF, and the output of a DCF is brutally sensitive to it. Move WACC by one point and the valuation can swing 15% or more. So the number isn't a formality. It's half the model.

The formula

$\text{WACC} = \frac{E}{V}\,r_e + \frac{D}{V}\,r_d\,(1-t)$

Read it left to right. $E$ is the market value of equity, $D$ is the market value of debt, and $V = E + D$ is the whole thing. So $E/V$ and $D/V$ are just the weights: what fraction of the company's financing comes from stock versus loans. Then you multiply each weight by that source's cost. $r_e$ is the cost of equity, $r_d$ is the cost of debt, and $t$ is the tax rate.

Two pieces need unpacking: the weights and that $(1-t)$ on the debt term. Get those wrong and the whole thing is off.

Use market values, not book

The weights come from market values. Equity weight is market capitalization (share price times shares outstanding), not the equity line on the balance sheet. Debt is the market value of debt, which for most companies you can approximate with the balance-sheet figure since debt trades close to par.

Why does this matter so much? Book equity is a historical, accounting number. It can be a tiny fraction of what the company is actually worth, or in a beaten-down business it can be larger than market cap. The whole point of WACC is the return investors demand today to hold the securities at today's prices. Yesterday's accounting entries don't set anyone's required return.

Common mistake

Building the weights off book values from the balance sheet, or forgetting the after-tax adjustment on debt. These are the two errors interviewers fish for, and candidates hit both constantly. Weights are market: equity is market cap, debt is market value. And the cost of debt is always after tax, because interest is deductible. Miss either one and your discount rate is simply wrong, which quietly corrupts every number downstream in the model.

Why the cost of debt is after-tax

Interest expense is tax-deductible. It reduces taxable income, so it reduces the tax bill. That saving is the tax shield, and it makes debt cheaper than its stated rate.

Say a company borrows at a 10% rate and the tax rate is 20%. The government effectively refunds 20% of the interest through lower taxes, so the real, after-tax cost of that debt is $10\% \times (1 - 0.20) = 8\%$ . You use 8%, not 10%, in WACC. Equity gets no such break. Dividends and buybacks are paid out of after-tax dollars, so there's no $(1-t)$ on the equity term.

Where the two costs come from

The cost of debt is the easier one. It's roughly the yield the company pays on its current borrowing, or the yield on comparable debt of similar rating. Then you tax-adjust it.

The cost of equity is harder because equity has no stated coupon. You back into it with the capital asset pricing model:

$r_e = r_f + \beta \times (r_m - r_f)$

The risk-free rate ( $r_f$ ) is typically the 10-year Treasury yield. Beta ( $\beta$ ) measures how much the stock moves with the market. And $(r_m - r_f)$ is the equity risk premium, the extra return investors demand for holding stocks over risk-free bonds. Full mechanics live in the CAPM lesson, but the intuition is clean: riskier stock, higher beta, higher required return.

A worked WACC

Put it together with round numbers. A company is 75% equity, 25% debt by market value. Cost of equity is 12%, pre-tax cost of debt is 8%, tax rate is 25%.

| Component | Weight | Cost | Contribution | |---|---|---|---| | Equity | 75% | 12% | $0.75 \times 12\% = 9.0\%$ | | Debt (after-tax) | 25% | $8\% \times (1-0.25) = 6\%$ | $0.25 \times 6\% = 1.5\%$ | | WACC | | | 10.5% |

The after-tax cost of debt is $8\% \times 0.75 = 6\%$ . Weighted contributions: $9.0\% + 1.5\% = 10.5\%$ . That 10.5% is what you'd drop into the DCF as the discount rate.

Why WACC discounts unlevered cash flows

Here's the conceptual link people miss. WACC blends the returns of all capital providers, debt and equity together. So it has to be paired with the cash flow that belongs to all of them: unlevered free cash flow, the cash the business generates before any interest is paid out to lenders.

Key insight

Match the cash flow to the discount rate. Unlevered cash flow belongs to everyone who funded the business, so you discount it at WACC and get enterprise value. Levered cash flow is what's left for equity after debt is served, so you'd discount it at the cost of equity and get equity value directly. Never cross the wires: unlevered with WACC, levered with cost of equity.

If you discounted unlevered cash flow at the cost of equity, you'd be demanding an all-equity return on a stream that debt helped fund. The math would double-count the risk and understate the value.

A subtlety worth knowing

There's a small circularity baked into WACC. The weights depend on the market value of equity, but in a DCF the market value of equity is partly what you're solving for. In practice bankers sidestep this. They assume a target capital structure, often the mix the company is guiding toward or the norm for its industry, rather than iterating the current one to convergence. If a business is temporarily over-levered after an acquisition, you don't want that distorted snapshot driving the discount rate for the next decade.

Interview tip

When asked "what's WACC," don't just recite the formula. Say it as a story: "It's the blended after-tax return debt and equity holders require, weighted by market value, and it's the rate I use to discount unlevered cash flows to enterprise value." Then, unprompted, name the two traps: market weights not book, and the after-tax adjustment on debt. Volunteering the pitfalls before the follow-up comes is the depth that separates you in a Superday. It signals you've actually built the thing, not memorized it.

Glossary

New to the lingo? Every term used above, in plain English.

WACC (Weighted Average Cost of Capital): The blended rate a company pays to fund itself with both debt and equity. In a DCF it is the discount rate used to bring future cash back to today.
Cost of equity: The return shareholders require to own a company stock, given its risk. Usually estimated with CAPM, and it is always higher than the cost of debt.
Cost of debt: The rate a company pays to borrow. Because interest is tax-deductible, the after-tax cost of debt is what goes into WACC, and it is cheaper than equity.
Market capitalization: The total value of a public company shares, calculated as share price times the number of shares outstanding. It is the same thing as equity value for a public company.
Tax shield: The tax a company saves because an expense is deductible. Depreciation, for example, lowers taxable income, so it saves cash on taxes even though it is non-cash.
Risk-free rate: The return on an investment with essentially no risk, usually the yield on a long-term government bond. It is the starting point for the cost of equity.
Beta: A measure of how much a stock moves relative to the overall market. A beta of 1 moves with the market, above 1 is more volatile, below 1 is less. It feeds the cost of equity.
Equity risk premium (ERP): The extra return investors demand for holding stocks instead of risk-free government bonds. Historically it runs around 5% to 7%.
Unlevered free cash flow: The cash a business generates before any debt payments, so it belongs to all investors, both lenders and shareholders. This is the cash flow used in a DCF.
EV (Enterprise Value): The value of a company’s whole operations, to every investor including lenders and shareholders. It does not depend on how the company is financed.
Equity Value: The slice of a company that belongs to its shareholders. For a public company this is the market capitalization (share price times shares outstanding).
Capital structure: The mix of debt and equity a company uses to fund itself. More debt is cheaper but riskier, and finding the right balance affects both value and risk.

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