WACC Explained Simply: Cost of Capital for Interviews
Master WACC calculations for finance interviews. Learn the formula, components (cost of equity, cost of debt), and common interview questions.
WACC (Weighted Average Cost of Capital) is the discount rate used in DCF valuations. It represents the minimum return a company must earn to satisfy all its capital providers—both debt holders and equity investors.
What is WACC?
Note
WACC is the blended cost of all capital sources (debt and equity), weighted by their proportions in the company's capital structure. It answers: "What return must this company generate to keep its investors happy?"
The WACC Formula
WACC = (E/V × Re) + (D/V × Rd × (1 - T))Weight cost of equity and after-tax cost of debt by their proportions in the capital structure.
Test Yourself
Interview Question
Company has 60% equity (Re=12%), 40% debt (Rd=6%), tax rate 25%. What is WACC?
Cost of Equity (Re)
Cost of equity is what shareholders expect to earn. Since there's no contractual return (unlike debt interest), we estimate it using the Capital Asset Pricing Model (CAPM).
Re = Rf + β × (Rm - Rf)The expected return on equity equals the risk-free rate plus a risk premium based on the stock's sensitivity to market movements.
Test Yourself
Interview Question
A stock has beta of 1.5. If the market drops 10%, what would you expect to happen to this stock?
CAPM Components
| Term | Definition | Note |
|---|---|---|
| Risk-Free Rate (Rf) | 10-year Treasury yield | ~4-5% currently |
| Beta (β) | Volatility vs market. β=1 means market risk | From regression or comps |
| Market Risk Premium | Extra return for holding stocks vs risk-free | ~5-7% historically |
Understanding beta and CAPM is essential for calculating cost of equity—the largest component of WACC for most companies.
Cost of Debt (Rd)
Cost of debt is the interest rate the company pays on its borrowings. This is easier to observe than cost of equity—look at:
- Yield on the company's existing bonds
- Interest rates on recent debt issuances
- Credit rating-based yield estimates
Test Yourself
Interview Question
Why do we multiply cost of debt by (1 - tax rate) in WACC but NOT cost of equity?
After-Tax Cost of Debt
We use Rd × (1 - T) because interest is tax-deductible. This "tax shield" reduces the effective cost of debt.
Example: If cost of debt is 6% and tax rate is 25%:
After-tax cost = 6% × (1 - 0.25) = 4.5%
What Drives WACC Higher or Lower?
Test Yourself
Interview Question
A company increases its debt from 20% to 60% of capital structure. What happens to WACC?
WACC Drivers
| Term | Definition |
|---|---|
| Interest Rates | Higher rates → Higher Rf → Higher Re → Higher WACC |
| Company Risk (Beta) | Riskier business → Higher β → Higher Re → Higher WACC |
| Leverage | More debt → Initially lowers WACC, but rises at extreme leverage |
| Tax Rate | Higher tax → Greater tax shield → Lower after-tax Rd |
| Credit Quality | Lower credit rating → Higher Rd → Higher WACC |
Estimating Beta for Private Companies
Test Yourself
Interview Question
How do you estimate beta for a private company?
Common Mistakes
Warning
- Using book value instead of market value for weights
- Forgetting the tax shield on debt
- Using levered beta with unlevered betas without adjusting
- Using company's marginal tax rate when effective rate is more appropriate
- Ignoring that WACC changes over time as capital structure evolves
Key Takeaways
Key Takeaway
- WACC = blended cost of debt and equity capital
- Cost of Equity calculated via CAPM: Re = Rf + β(Rm - Rf)
- Cost of Debt is after-tax because interest is tax-deductible
- Use market values for weights, not book values
- Match your discount rate to your cash flow: WACC for unlevered FCF
Related Valuation Guides
- Walk Me Through a DCF — WACC is the discount rate in DCF analysis
- Enterprise Value vs Equity Value — Understanding what WACC discounts
- LBO Explained Simply — How leverage affects cost of capital