In the last article about financial formulas, I focused on Internal Rate of Return – IRR, which helps us evaluate investment projects. For example, we previously calculated the return on an apartment investment, where we planned to rent it out for a while and then sell it. I mentioned that IRR (in %) is often compared against a benchmark, which represents the minimum acceptable return for the project. In the business world, this benchmark is often (but not always) the WACC – short for “Weighted Average Cost of Capital.”
WACC – Explanation and Formula for Weighted Average Cost of Capital
As mentioned, WACC is the weighted average cost of capital. It’s expressed in % and shows how much it costs the owners to use their resources. A company’s financing comes in two flavors: equity and debt. Taxes also play a role, so the WACC formula has several components. That said, it’s not rocket science.
WACC Formula
The formula looks like this 1
Where:
- WACC – weighted average cost of capital
- Equity (E) – Shareholders equity
- Total Capital (E+L) – total capital (equity + debt)
- Liabilities (L) – Debt
- Requity – cost of equity
- Rliabilities – cost of debt
- tc – corporate income tax rate
The formula has two parts:
- The first part (E/Total*Re) calculates the cost of equity
- The second part deals with the cost of debt
- (1-tc) accounts for the tax shield
Equity Component
The first component of WACC is the average cost of equity. Equity includes owners’ contributions (cash or non-cash) and other elements like capital funds, retained earnings, and accumulated results from previous periods. You can find the equity value in the financial statements.
This is the main part that owners risk when running the business. That’s why the cost of equity (Re) is generally higher than the cost of debt. Equity is riskier than debt. Calculating Re is trickier than Rd because debt costs are straightforward (we know loan amounts and interest rates), whereas equity involves risk and often requires modeling and estimation.
One popular method is the Capital Asset Pricing Model (CAPM) 2. It uses market parameters to estimate equity costs. A limitation is that if there’s no proper market or comparable companies, we need alternative approaches. I’ll cover this in more detail another time.
Debt Component
The second component is the cost of debt, which is simpler. Just list all external financing – loans, bonds, etc. – calculate the weighted average interest rate, and plug it into the formula. Debt amounts can also be found in the financial statements.
Tax Shield
In the WACC formula, the (1-tc) component adjusts debt costs for taxes. Interest is usually tax-deductible, creating a “tax shield” that reduces the effective cost of debt.
However, it’s debatable whether to apply this if the company expects losses. In that case, the tax shield might not exist in the current year. Past losses can sometimes be applied retrospectively, but this depends on local tax rules.
For example, interest on loans for fixed assets can usually apply the tax shield (effects show up via depreciation), but interest on loans between related parties might not be deductible. Applying the tax shield incorrectly could distort WACC. In such cases, it might be better to split debt costs into deductible and non-deductible parts, depending on materiality.
Relationship Between IRR and WACC in Investment Decisions
Once we calculate WACC, we know the percentage cost of capital. This gives a benchmark for evaluating investments. Ideally, an investment’s return should exceed WACC. Of course, we want to calculate WACC as accurately as possible first.
If an investment’s IRR (%) is higher than WACC (%), it’s generally a good investment. The reverse is also true. Technically, we could assess a project using just NPV (where WACC acts as the discount rate):
- If NPV > 0, the project is profitable, even without comparing IRR to WACC
- To know how much better or worse a project is compared to WACC, IRR helps us quantify the difference in %
Knowing that IRR exceeds WACC helps us understand profitability and can provide a safety buffer against WACC estimation errors.
Reference
- Wikipedia, Weighted Average Cost of Capital [online]. [cited 2025-10-29]. Available from: https://cs.wikipedia.org/wiki/V%C3%A1%C5%BEen%C3%BD_pr%C5%AFm%C4%9Br_n%C3%A1klad%C5%AF_kapit%C3%A1lu
- Investopedia, How Do I Use the CAPM to Determine Cost of Equity? [online]. [cited 2025-10-29]. Available from: https://www.investopedia.com/ask/answers/022515/how-do-i-use-capm-capital-asset-pricing-model-determine-cost-equity.asp