Weighted average cost of capital (WACC) represents the average rate a company must pay to finance its assets, weighted by the proportion of each funding source — equity and debt. It serves as the minimum return a business must earn on existing assets to satisfy its capital providers and is the standard discount rate for NPV and DCF analysis.
Formula
WACC = (E/V x Re) + (D/V x Rd x (1-T))In Depth
WACC is the blended cost of all the capital a company uses, weighted by how much of each type makes up the capital structure. It combines the cost of equity (what shareholders require) and the after-tax cost of debt (what lenders charge, adjusted for the tax shield on interest payments).
The formula is: WACC = (E/V x Re) + (D/V x Rd x (1-T)), where E = market value of equity, D = market value of debt, V = E + D, Re = cost of equity, Rd = cost of debt, and T = corporate tax rate.
The cost of equity is typically estimated using the Capital Asset Pricing Model (CAPM): Re = Risk-Free Rate + Beta x Market Risk Premium. For UK companies, the risk-free rate is usually based on UK gilt yields, and the market risk premium reflects the expected return above gilts for investing in equities.
WACC serves multiple purposes in FP&A. As a discount rate in DCF valuations, it converts future cash flows to present value. As a hurdle rate for investment decisions, it sets the minimum acceptable return — any investment earning less than WACC destroys value. As a performance benchmark, comparing Return on Invested Capital (ROIC) against WACC determines whether the business is creating value.
FP&A teams should recalculate WACC periodically as interest rates, market conditions, and capital structure change. The current UK interest rate environment, with base rates significantly higher than the near-zero period of 2009-2021, has materially increased WACC for many UK businesses.
Real-World Example
A UK company has £30M equity (valued by the market) and £10M debt, making total capital £40M. The cost of equity (via CAPM) is 11% and the pre-tax cost of debt is 6%. With a 25% UK corporation tax rate, after-tax cost of debt is 4.5%. WACC = (30/40 x 11%) + (10/40 x 4.5%) = 8.25% + 1.125% = 9.375%. This 9.4% is used as the discount rate for all NPV and DCF analyses.
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