Weighted Average Cost of Capital
The weighted average cost of capital is the return a company must earn on its investments to satisfy everyone who funds it — its lenders and its shareholders — blended in proportion to how much of the company each finances, with the cost of debt taken after tax. It is the rate at which a discounted cash flow valuation discounts the company's future cash flows.
- Also known as
- WACC, Cost of capital, Discount rate
- Used at
- the discount rate of a discounted cash flow, and the hurdle rate for investment decisions
- Formula
- (E ÷ V) × cost of equity + (D ÷ V) × cost of debt × (1 − tax rate), where V = E + D
- Cost of equity
- risk-free rate + beta × equity risk premium (the capital asset pricing model), plus size and specific premia
- Typical range
- 8–11% for a listed payments company; 15–25% for an early-stage fintech valued by a venture investor
- Sensitivity
- each point added to the rate cuts a growth company's DCF value by roughly a tenth
How the weighted average cost of capital works in practice
Every euro a company invests has to earn at least what the people who provided it could have earned elsewhere at the same risk. Lenders want their interest; shareholders want a return that pays them for the risk of coming last. The weighted average cost of capital blends the two: if a company is 70% equity costing 14% and 30% debt costing 6% before tax at a 25% tax rate, its cost of capital is 0.7 × 14% + 0.3 × 6% × 0.75 = 11.15%. A project — or an acquisition — that returns less than that destroys value even if it is "profitable".
The cost of debt is observable: it is what the company pays, or would pay, to borrow. The cost of equity is not, and estimating it is where valuations diverge. The standard method starts from a risk-free government bond yield, adds an equity risk premium scaled by the company's beta — how much its value moves with the market — and then adds premia for size and for specific risks. A small, unlisted fintech with a single product and one regulator has a lot of specific risk, and its cost of equity reflects it; a venture investor's 25% hurdle is a cost of capital by another name.
For a fintech the capital structure deserves one more thought. Regulatory capital that a licensed firm must hold is not free to be invested and is not part of the operating business being valued, and a lender's warehouse line funds its loan book rather than its operations. Both are kept out of the weighting, or the rate is wrong.
Example
A buyer values a merchant-acquiring company. Risk-free rate 3.5%, beta 1.3, equity risk premium 5.5%, size premium 2%: cost of equity is 3.5% + 1.3 × 5.5% + 2% = 12.65%. The company could borrow at 7% and pays 25% tax, so after-tax cost of debt is 5.25%. At a target structure of 75% equity and 25% debt, the cost of capital is 0.75 × 12.65% + 0.25 × 5.25% = 10.8%, which rounds to the 11% the buyer uses. Discounting the same forecast at 10% instead would raise its valuation by €6m on a €70m business — which is why the seller's adviser argues for a lower beta.
Common mistakes
- Using the buyer's cost of capital to value the target, rather than a rate that reflects the target's risk. - Taking the cost of debt before tax, which overstates the rate. - A beta borrowed from listed payments companies for an unlisted lender with different risks. - Weighting by book values of debt and equity instead of market values. - Treating the number as a fact: it is an estimate, and the valuation should show what happens two points either side.