What is the weighted average cost of capital (WACC)?
Short Answer
WACC is the average cost of all capital sources (debt and equity) a company uses, weighted by their proportions — it is the minimum return the company should generate to satisfy all investors.
Full Explanation
WACC = (E/V × Re) + (D/V × Rd × (1 − Tc)), where E = market value of equity, D = market value of debt, V = E + D, Re = cost of equity, Rd = cost of debt, Tc = corporate tax rate. For a company with £10M equity (cost 12%) and £5M debt (cost 6%, after 25% tax = 4.5%), WACC = (10/15 × 12%) + (5/15 × 4.5%) = 8.5% + 1.5% = 10%. This means the company should target at least 10% annual returns to satisfy all investors. WACC is used as the discount rate in DCF valuation — all cash flows are discounted at WACC to present value. Higher WACC (riskier companies, higher debt) means future cash flows are worth less today. Lower WACC (stable companies, lower debt) means future cash flows are worth more. For intangible asset valuations, asset-specific discount rates are adjusted from WACC (adding risk premiums for assets riskier than the business as a whole). Understanding WACC is critical for valuation: a £1M asset discounted at 10% over 10 years is worth £614K, but at 20% is worth only £189K — WACC assumption is load-bearing.
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