WACC — the weighted average cost of capital — is the single number that powers a DCF valuation. It's the rate you discount future cash flows by. Get it wrong and the whole valuation moves. Here's how it's built.
A company funds itself with two kinds of money: equity (shareholders) and debt (lenders). Each has a cost. WACC blends them by how much of each the company uses.
Where E is the market value of equity, D is the market value of debt, and V = E + D. The (1 − tax rate) piece exists because interest on debt is tax-deductible — debt is cheaper than it looks.
You usually estimate the cost of equity with the Capital Asset Pricing Model:
Beta (β) measures how much the stock moves relative to the market. A higher beta means more risk, so shareholders demand a higher return.
This is the effective interest rate the company pays on its borrowings — typically the yield on its debt — then reduced by the tax shield.
| If WACC... | Then valuation... |
|---|---|
| goes up | goes down (future cash discounted harder) |
| goes down | goes up (future cash worth more today) |
Because terminal value sits far in the future, a 1% change in WACC can swing a DCF dramatically — which is why analysts run a sensitivity table on it.