How to calculate weighted average cost of capital, step by step
Weighted average cost of capital is one rate that answers one question: what does this company pay for its money? The calculation needs five numbers: the market value of equity, the market value of debt, the cost of equity, the cost of debt and the corporate tax rate. On $600,000 of equity at a 12% cost of equity and $400,000 of debt at a 6% cost of debt after a 25% tax rate, the weighted average cost of capital is 9.00% — a rate, not a value in dollars, and it is below the 12% cost of equity because the debt is cheaper than the equity.
The definition is the average of what the company pays its shareholders and its lenders, weighted by how much of each it uses. The weight of equity is the market value of equity divided by the total capital, and the weight of debt is the market value of debt divided by the total capital. The cost of debt is taken after tax, because interest is tax-deductible — a 6% loan at a 25% tax rate costs 4.50% after tax, because the company saves a quarter of the interest in tax. So the weighted average cost of capital is the weight of equity times the cost of equity, plus the weight of debt times the after-tax cost of debt.
The worked example, line by line. Step 1 — the total capital: $600,000 + $400,000 = $1,000,000. Step 2 — the weight of equity: $600,000 ÷ $1,000,000 = 60.00%. Step 3 — the weight of debt: $400,000 ÷ $1,000,000 = 40.00%. Step 4 — the after-tax cost of debt: 6% × (1 − 25%) = 4.50%. Step 5 — the equity component: 60.00% × 12% = 7.20%. Step 6 — the debt component: 40.00% × 4.50% = 1.80%. Step 7 — the weighted average cost of capital: 7.20% + 1.80% = 9.00%. Work it yourself in the weighted average cost of capital calculator.
A note on the rounding: the weights are displayed to two decimals, half-up. With the fractional inputs the unrounded weight of equity is 0.683761 — it displays as 68.38% — and the unrounded after-tax cost of debt is 4.576550% — it displays as 4.58% — and the unrounded weighted average cost of capital is 9.221647% — it displays as 9.22%. The one hundredth is rounding, not a mistake.
What the answer means
A weighted average cost of capital of 9.00% means every dollar of new investment must earn at least 9.00% to cover what the shareholders and the lenders demand — for every dollar of capital, the company pays about 9 cents a year. A project earning above 9.00% creates value: at a 9.00% hurdle, a project earning 12% has a positive net present value. A project earning below 9.00% destroys value: at a 12% cost of debt and a 25% tax rate, a project earning 8% would fall short and the net present value would be negative. A project earning exactly 9.00% breaks even. The number alone never says whether 9.00% is a lot or a little — that depends on the risk. Compare it against the return of the project before you decide.
When there is no weighted average cost of capital
Some capital structures have no weighted average cost of capital, and the honest answer is that it is undefined. At $0 of equity and $0 of debt there is no capital to weight, so there is no average to take — and the calculator says so plainly. At $0 of debt the weighted average cost of capital is the cost of equity — 12.00% — because the shareholders are the only funders. At $0 of equity the weighted average cost of capital is the after-tax cost of debt — 4.50% — because the lenders are the only funders. In each case the calculator shows the figure instead of hiding it.
WACC vs cost of equity
The weighted average cost of capital and the cost of equity answer different questions, and mixing them up is the most common mistake. The cost of equity is what the shareholders demand — 12% here. The weighted average cost of capital is the average of that and the after-tax cost of debt, weighted by how much of each the company uses — 9.00% here. One is one ingredient, the other is the average. A company with more debt has a lower weighted average cost of capital than its cost of equity, because the debt is cheaper — but it also has more risk, because the debt must be repaid whatever happens. Use the cost of equity when you want what the shareholders demand, and use the weighted average cost of capital when you want what the whole company pays. Work it out in the weighted average cost of capital calculator.
WACC vs IRR
The weighted average cost of capital and the internal rate of return answer different questions too. The weighted average cost of capital is the hurdle: what the company pays for its money. The internal rate of return is the return: what a project earns. On $600,000 of equity and $400,000 of debt the weighted average cost of capital is 9.00%, and on $10,000 invested with $3,000 a year coming back for 5 years the internal rate of return is 15.24%. One is the bar, the other is the jump. A project whose internal rate of return beats the weighted average cost of capital creates value — 15.24% against a 9.00% hurdle — and a project whose internal rate of return falls short destroys it. Use the weighted average cost of capital when you want the hurdle, and use the internal rate of return when you want the project’s return. Work out the return in the internal rate of return calculator.
Common mistakes
The first mistake is using book values instead of market values — the balance sheet says what the equity was worth years ago, and the market says what it is worth today, so the weights come out wrong. The second is forgetting the tax shield — using the 6% cost of debt instead of the 4.50% after-tax cost, which pushes the answer to 9.60% instead of 9.00%. The third is using the cost of debt before tax in the debt component and after tax nowhere else — the tax only touches the debt, never the equity, because dividends are not tax-deductible. The fourth is rounding the weights and adding the rounded components — the rounded weights add to 100.00% here, but with fractional inputs they can add to 99.99% or 100.01%. Work it out in the weighted average cost of capital calculator, and check the net present value calculator and the internal rate of return calculator before you decide what the answer means.