corporate-finance
The weighted average cost of capital is the opportunity cost of the operating capital structure: each source of capital is costed at market required returns, weighted by market value, with debt after tax. It is the hurdle for projects with the same risk and financing mix as the firm.
The weighted average cost of capital is assembled, not guessed. CFA corporate-finance readings and Damodaran's cost-of-capital workbooks use the same logic: estimate required returns on equity and debt at market terms, weight them by market (or target market) proportions, and reduce the debt cost by the tax shield if interest is deductible.
WACC = Σ_i w_i × r_i (with r_debt after tax)
The acronym WACC is the label on the output. This page is the derivation of the inputs.
CAPM remains the default:
Re = Rf + β × ERP (+ CRP + size, if used and disclosed)
Rf in the same currency as the cash flows. β should be an operating (asset) beta relevered to the target gearing, not a noisy two-year raw equity beta on a thinly traded name. ERP is a forward-looking premium, not last year's stock-market return.
Rd is the current yield the firm would pay on new debt of similar seniority and duration, not the coupon on a 2017 bond. For private firms, look at credit analogues and coverage, not the owner's handshake rate with a house bank if that rate is not transferable to a buyer.
Use target structure if the DCF assumes the firm will be financed that way (typical in EV/FCFF models). Using today's accidental net-cash pile as 0% debt forever understates WACC if the buyer will gear it. Conversely, using peak distressed gearing overstates the shield and understates WACC.
Invented Lumen Dental Group, illustration only. Currency EUR.
| Building block | Working |
|---|---|
| Peer unlevered median beta | 0.70 |
| Target D/E (market) | 0.40 → D/V = 28.6%, E/V = 71.4% |
| Relevered β | 0.70 × [1 + (1 − 0.21) × 0.40] = 0.92 |
| Rf / ERP | 2.6% / 4.5% |
| Re | 2.6% + 0.92 × 4.5% = 6.7%; +1.5% size = 8.2% |
| Rd (new senior) | 5.2% |
| After-tax Rd | 5.2% × (1 − 0.21) = 4.1% |
| WACC | 0.714 × 8.2% + 0.286 × 4.1% = 7.0% |
A buyer whose fund hurdle is 15% equity IRR is asking a different question (return on their equity with their leverage). Do not "derive" 15% as the firm's WACC.
Purchase-price DCFs, impairment models, and project sanctions all inherit this derivation. In M&A, arguing WACC is often a proxy war about risk and gearing. Separate three rates in the memo: asset WACC, buyer's levered equity hurdle, and optional synergy discount rate. Collapsing them produces fake precision.
CAPM is a model with well-known empirical limits. Illiquid private firms need judgement beyond listed betas. Changing capital structure over the forecast is cleaner in APV (unlevered cost of equity plus PV of shield) than in a annually moving WACC unless you are careful.
Dazur derives WACC in the open so a principal can disagree with ERP or size without rejecting the whole valuation. For Iberian and wider European mid-market deals, the honest debate is usually size, country, and whether target gearing is financeable—not whether the formula has a fourth term nobody can name.