Cost of capital: calculating and applying WACC in corporate decisions
- Graziano Stefanelli
- Aug 15
- 4 min read
The cost of capital represents the minimum return a company must earn on its investments to satisfy its investors, both debt holders and equity holders. It is a cornerstone of corporate finance because it serves as the benchmark rate against which potential projects, acquisitions, and strategic initiatives are evaluated.
A cost of capital that is too high can make otherwise profitable opportunities appear unattractive, while a cost that is underestimated can lead to investments that erode value. The most widely used approach to determine this benchmark is the Weighted Average Cost of Capital (WACC), which blends the cost of debt and the cost of equity according to their proportion in the company’s capital structure. This figure directly influences capital budgeting decisions, valuation models, and the company’s long-term strategic positioning.
The calculation of WACC integrates both the cost of debt and the cost of equity into a single measure.
WACC reflects the average rate of return required by all providers of capital, weighted according to the firm’s mix of financing. Under both US GAAP and IFRS, while WACC itself is not recorded in financial statements, its inputs come directly from reported data such as interest expense, liabilities, and shareholders’ equity. The formula incorporates the after-tax cost of debt — because interest expense reduces taxable income — and the expected return on equity, which reflects shareholder expectations given the company’s risk profile.
For example, if a company’s capital structure is 60% equity and 40% debt, with an after-tax cost of debt of 4% and a cost of equity of 10%, the WACC is calculated as follows:
This percentage represents the required return across all sources of capital. If an investment cannot generate at least this return, it is likely to destroy shareholder value.
The cost of debt reflects the effective interest rate adjusted for tax benefits.
Debt is often the cheaper component of capital because lenders take lower risk than shareholders — they have priority in repayment and may have collateral securing their claims. The pre-tax cost of debt is derived from the effective interest rate on existing borrowings or the yield to maturity on new debt issues.
Since interest is generally tax-deductible, the after-tax cost is calculated by multiplying the pre-tax rate by (1 − tax rate). For example, if a company pays 5% interest and faces a 25% tax rate, the after-tax cost of debt is 3.75%. In financial reporting, interest expense appears on the income statement, while the outstanding debt principal is shown on the balance sheet, making these figures readily available for cost calculations.
The cost of equity reflects shareholder return expectations based on market risk.
Unlike debt, equity carries no contractual obligation to pay a fixed return, but investors expect compensation for the risk they bear. The most common approach to estimate the cost of equity is the Capital Asset Pricing Model (CAPM), which uses the formula:
Cost of Equity = Risk-Free Rate + (Beta × Market Risk Premium)
Under this model, the risk-free rate is typically the yield on long-term government bonds, beta measures the stock’s volatility relative to the market, and the market risk premium represents the extra return investors demand for taking on equity risk. If the risk-free rate is 3%, beta is 1.2, and the market risk premium is 5%, the cost of equity is 9%. Although this figure is not directly reported in financial statements, the data to compute it — such as share price history and industry benchmarks — is publicly available for listed companies.
WACC is a decision-making tool for evaluating investments, valuations, and financing strategies.
In capital budgeting, WACC serves as the discount rate for calculating the net present value (NPV) of future cash flows. Projects with an expected return above WACC create value, while those below WACC destroy it. In valuation, WACC is used in discounted cash flow (DCF) models to estimate the present value of a company’s operations. It also influences financing decisions: if the after-tax cost of debt falls below the cost of equity, a company may increase leverage to reduce its WACC — but only to the point where the additional debt does not raise the overall cost due to increased risk.
A comparison of how WACC impacts different scenarios can be illustrated as follows:
Optimizing WACC requires a balance between risk and return that aligns with corporate strategy.
Management must continuously monitor both the cost of debt and the cost of equity to ensure that the capital structure remains competitive and sustainable. Excessive reliance on debt can initially lower WACC but eventually increase it if credit risk rises. Over-reliance on equity can keep financial risk low but lead to higher overall capital costs, making investments less attractive. The goal is to maintain a structure where WACC supports value creation while keeping financial flexibility intact. Under US GAAP and IFRS, transparency in reporting the components of debt and equity is critical, as investors and analysts rely on these disclosures to assess whether the company is using capital efficiently and making sound financing decisions.
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