What is WACC?
WACC — the weighted average cost of capital — is the blended annual return a company must earn to satisfy everyone funding it. It weights the cost of equity and the after-tax cost of debt by how much of each the company uses:
WACC = (E/V × Cost of Equity) + (D/V × Cost of Debt × (1 − Tax Rate))
where E is equity, D is debt, and V is E + D.
In a DCF it is the rate used to discount unlevered future cash flows. In capital allocation it is a starting point for assessing whether a project earns enough to cover its financing cost. The US example below uses a dated 10-year Treasury input of 4.94%, not a live rate. Changing the discount rate can materially change the valuation even if the cash-flow forecast stays the same.
Why the number matters more than the formula
The formula is arithmetic. The inputs require judgment, and the judgment can be worth a great deal of money.
Take a US business with $10M of next-year unlevered free cash flow, growing at 2.5% in perpetuity. At the illustrative 13.3% WACC derived below, its perpetuity value is $10M / (13.3% − 2.5%) = $92.6M. At an assumed 10%, the same cash flows are worth $133.3M.
Same company, same forecast, same growth rate: the 10% rate produces a valuation about 44% higher than the 13.3% rate. Neither rate is a recommendation; the comparison isolates the effect of the discount rate.
That is why the discount rate is the first thing a diligence team pressure-tests, and why "we used 10%" is not an answer. It is also why a DCF is only ever as defensible as its WACC derivation.
| Terminal growth | WACC 12% | 13% | 14% | 15% | 16% |
|---|---|---|---|---|---|
| 2.0% | $100.0M | $90.9M | $83.3M | $76.9M | $71.4M |
| 2.5% | $105.3M | $95.2M | $87.0M | $80.0M | $74.1M |
| 3.0% | $111.1M | $100.0M | $90.9M | $83.3M | $76.9M |
Illustrative perpetuity value of $10M in next-year unlevered free cash flow, using value = next-year cash flow / (WACC − growth). This simplified perpetuity is not a full DCF.
The formula, term by term
| Term | What it is | Where the number comes from |
|---|---|---|
| E/V | Equity as a share of total capital | Target capital structure, not today's accident |
| D/V | Debt as a share of total capital | Same |
| Cost of equity | The return equity holders require | CAPM, plus premiums for what CAPM misses |
| Cost of debt | The rate a lender charges you today | Your actual facilities, or a comparable credit |
| Tax rate | The marginal rate applicable to deductible interest | Interest deductions may reduce debt cost; actual tax rules and deduction limits matter |
Two things people get wrong here before they reach the hard part.
Use market weights, not book weights. Book equity is an accounting residual with no relationship to what the equity is worth. If you are valuing the company, the weights should reflect the capital structure you are valuing it at.
Use a target structure, not the current one. A company that happens to carry no debt this quarter does not have a 100%-equity cost of capital forever. Use the structure the business will run at once it is mature — which is usually where its comparable set sits.
Cost of debt: the easy half
Take the rate you would pay on new borrowing, not the average rate on legacy facilities and not the coupon on a loan you took out when rates were different. If you have facilities priced at market, use them. If you do not, assess debt of companies with a similar credit profile, including security and leverage.
Then apply the tax benefit where interest is deductible. In the worked example, a simplified 21% US federal corporate tax assumption makes 9.5% debt cost 9.5% × (1 − 0.21) = 7.505% after tax, displayed as 7.51%. This excludes state taxes and interest-deduction restrictions; the actual marginal rate applicable to deductible interest can differ, and a company unable to use the deduction should not assume the full shield.
The one trap: if your model already deducts interest before the cash flow you are discounting, you are counting the debt benefit twice. WACC discounts unlevered free cash flow — cash before financing. Discounting levered cash flow at WACC is one of the most common errors in a founder-built model, and it inflates the answer.
Cost of equity: where the argument actually is
The standard starting point is the Capital Asset Pricing Model:
Cost of Equity = Risk-Free Rate + (Beta × Equity Risk Premium)
| Input | What to use | Source |
|---|---|---|
| Risk-free rate | A Treasury yield matched to dollar cash flows and an appropriate horizon | 10-year US Treasury in this example |
| Equity risk premium | The excess return investors require over the risk-free rate | Damodaran's US ERP input used in this example |
| Beta | How much the business's returns move with the market | Relevered from a set of listed comparables |
Dated example inputs (not live quotes):
| US example | Risk-free rate | Equity risk premium |
|---|---|---|
| United States | 4.94% — 10-year Treasury, September 17, 2026 | 4.23% — Damodaran US, January 2026 |
These are the article's dated illustrative inputs, not independently verified live market quotes. Refresh the Treasury yield and equity risk premium for an actual valuation and document the observation dates. A stale input can distort the result in either direction.
Match the currency: dollar cash flows call for dollar-denominated discount-rate inputs. Do not combine cash flows and discount rates expressed in different currencies without a consistent currency conversion.
For a defensible discount rate tied to the company being assessed, business valuation services can establish and document the relevant inputs.
The private company problem
Here is what the textbooks skip. CAPM was built for listed companies. Yours has no share price, so it has no beta. It has no market capitalization, so it has no market-value weights. It may have no traded debt at all.
Three adjustments close the gap.
1. Borrow a beta and re-lever it
Take the observed betas of five to ten listed comparables. Strip out the effect of each one's capital structure to get an unlevered (asset) beta, take the median, then re-lever it at your target structure:
Relevered Beta = Unlevered Beta × (1 + (1 − Tax Rate) × D/E)
Use the median rather than the mean — comparable sets are small and one outlier distorts an average badly.
2. Add a size premium
Size may warrant a premium beyond the comparable-company CAPM estimate. For this illustrative US business below $250M of enterprise value, assume 3%; $250M is an example cutoff, not a converted or universally valid threshold. A 2–5% range is a sensitivity to test, not a blanket prescription. Document the selected data and avoid double-counting risks already captured elsewhere.
3. Add a company-specific premium — carefully
This can address risks such as customer concentration, key-person dependency, a single supplier, a short operating history, or no audited financial statements. The example assumes 2%, not a standard rate for every company.
This is an input open to abuse in both directions. A seller's advisor may argue for a lower premium; a buyer's advisor may argue for a higher one. Name each risk, state the basis points assigned, and check that the risk is not already reflected in the cash flows, beta, or size premium.
A worked example
A US software business with $10M of next-year unlevered free cash flow plans to run at 25% debt and 75% equity once mature. All premiums, leverage, borrowing costs, and the federal tax assumption below are illustrative; this is not a live quote for the business.
| Step | Input | Value |
|---|---|---|
| Risk-free rate | 10-year Treasury, September 17, 2026 | 4.94% |
| Equity risk premium | Damodaran US, January 2026 | 4.23% |
| Unlevered beta | Median of listed comparables | 1.00 |
| Target D/E | 25% / 75% | 1/3 |
| Relevered beta | 1.00 × (1 + (1 − 0.21) × (0.25 / 0.75)) | 1.263333… |
| CAPM cost of equity | 4.94% + (1.263333… × 4.23%) | 10.2839% |
| Size premium | Illustrative US business below $250M EV | +3.0% |
| Company-specific premium | Top 3 customers = 54% of revenue | +2.0% |
| Cost of equity | 10.2839% + 3.0% + 2.0% | 15.2839% |
| Pre-tax cost of debt | Current facility pricing | 9.5% |
| After-tax cost of debt | 9.5% × (1 − 0.21) | 7.505% |
| WACC | (0.75 × 15.2839%) + (0.25 × 7.505%); calculate with full-precision beta | 13.3392% ≈ 13.3% |
The calculation uses the unrounded beta (1.263333…) and cost of equity (15.2839%) before rounding the WACC to one decimal place. The federal 21% assumption simplifies the tax shield: it excludes state tax and deduction restrictions, and the actual marginal rate applicable to deductible interest matters. Every assumption is open to challenge; document and refresh the dated inputs before using this rate for a real decision.
WACC is not your hurdle rate
These get used interchangeably and they are not the same thing.
WACC is what your capital costs. It is an average across the whole business — every product, every market, every project you already run.
A hurdle rate is what you require from a specific decision. It should reflect the risk of that decision, not the average risk of the company.
Discounting a speculative new-market launch at the same rate as a maintenance capital expenditure project can overvalue the risky project and undervalue the safer one. An illustrative hurdle might add a risk-based margin above WACC, but the appropriate margin depends on the project, the forecast, and which risks are already reflected in cash flows.
| WACC | Hurdle rate | |
|---|---|---|
| Answers | What does our capital cost? | Is this specific project worth doing? |
| Scope | The whole company | One decision |
| Illustrative level | The calculated figure | WACC plus a project-specific margin, if warranted |
| Used for | Discounting a DCF, valuation | Capital allocation, go/no-go |
Five WACC mistakes worth checking for
1. Discounting levered cash flow at WACC. Double-counts the tax shield. WACC belongs with unlevered free cash flow.
2. Book weights instead of market weights. Book equity is an accounting residual. It has nothing to do with what the equity is worth.
3. A mean comparable beta instead of a median. With a set of six to ten, one outlier drags the average somewhere indefensible.
4. A currency mismatch. Dollar cash flows discounted using inputs from another currency without reconciling the currency assumptions.
5. A WACC hardcoded into a cell. If your discount rate is typed as 13% inside a formula rather than driven from an inputs tab, nobody can see the derivation — including you, six months later. This is the single most common defect we find in models that come in for review.
When the underlying workbook needs a transparent WACC schedule and sensitivity analysis, financial modeling services can build those calculations into the model.
Frequently asked questions
Clear answers to the questions founders ask most often.
The blended annual return required by lenders and shareholders. If the illustrative WACC is 13.3%, a project with comparable risk needs to generate a return above its capital cost to create value; WACC alone is not a guarantee of a profitable decision.
There is no universally good number. The defensible rate depends on current market inputs, comparable-company risk, financing mix, taxes, and the company's own circumstances. The 13.3% worked example is illustrative, not a benchmark or a recommended rate for every US private company.
Start with the same formula and a beta derived from listed comparables, relevered to a justified target capital structure. Consider size and company-specific premiums only when supported by the facts and not double-counted. The example assumes 3% and 2%, respectively, rather than prescribing those rates for every business.
Lenders generally rank ahead of shareholders, so they may demand a lower return. Deductible interest can also reduce the after-tax cost, but the benefit depends on the actual marginal tax rate and applicable deduction limits.
Lower, all else equal: a higher discount rate makes future cash flows worth less today. For $10M in next-year free cash flow growing at 2.5% perpetually, using 13.3% gives $92.6M versus $133.3M at 10%, about 44% higher at the lower rate.
Cost of equity is the return shareholders require. WACC blends that with the after-tax cost of debt, weighted by how much of each the company uses. If a company has no debt, the two are the same.
Yes. It moves with interest rates, with your capital structure, and with the company's risk profile. A model that carries the same discount rate across a ten-year forecast is asserting that none of those will change.
Related reading
- The 3-statement model: how to build one that survives investor scrutiny
- The 13-week cash flow forecast
- Contribution margin: what it actually tells you
Need a valuation with the discount rate derived rather than asserted? See business valuation services. Need the model underneath it rebuilt? See financial modeling services.