The formula
WACC = (E/V) × Re + (D/V) × Rd × (1 − T), where E = market value of equity, D = market value of debt, V = E + D (total capital), Re = cost of equity, Rd = cost of debt (pre-tax), and T = corporate tax rate. The (1 − T) term adjusts for the tax deductibility of interest — debt is cheaper than equity on an after-tax basis because interest payments are tax-deductible, while dividends are not. This tax shield is one reason companies use debt in their capital structure (as formalised by Modigliani-Miller with taxes).
Estimating the cost of equity
The cost of debt is observable — it is the yield on the company’s bonds or the rate on its bank facilities. The cost of equity is unobservable and must be estimated. The standard approach uses CAPM: Re = Rf + β × ERP, where Rf is the risk-free rate (typically the 10-year gilt or Treasury yield) and ERP is the equity risk premium (the expected excess return of the market over the risk-free rate, typically estimated at 4–6% for developed markets). The equity risk premium and the appropriate beta are both contested, which is why professional valuations show wide ranges even when analysts agree on cash flows.
WACC sensitivity and valuation impact
WACC is the most powerful lever in DCF valuation. A 1% decrease in WACC (say from 9% to 8%) applied to a terminal value calculation can increase the implied enterprise value by 15–25%. This sensitivity is why investment bankers are often accused of "reaching" for low discount rates to justify higher valuations in sell-side analyses. In reality, the appropriate WACC depends on the systematic risk of the specific cash flows being valued — a stable utility business with predictable regulated revenues deserves a much lower WACC than an early-stage technology company with uncertain cash flows.
“WACC is the cost of keeping investors in the room. Every pound of capital has an expectation. WACC is the blended total of those expectations.”
What this means for you
When scrutinising a DCF analysis, always examine the WACC assumption first. Ask: is the risk-free rate current? Is the equity risk premium sensible? Is the beta derived from the right peer group? Is the capital structure at target weights or current weights? Then run a sensitivity table: if WACC is 1% higher or lower, how does the implied share price change? This exercise routinely reveals that the conclusion of a valuation is driven more by the discount rate assumption than by the cash flow forecasts — which is the most important thing to understand about DCF in practice.