3.3 WACC

Assembling WACC from the Pieces You Already Have

The weighted average cost of capital (WACC) is the blended required return on the firm's invested capital. CFI's core formula, when the firm is financed with common equity and debt, is:

WACC = (E/V × Re) + ((D/V × Rd) × (1 − T))

Where:

• E = market value of equity (market capitalization)
• D = market value of interest-bearing debt
• V = E + D (invested capital at market)
• Re = cost of equity from CAPM
• Rd = cost of debt, measured as the yield to maturity (YTM) on existing debt of similar risk, not the coupon
• T = marginal tax rate that applies to interest deductions

The tax shield applies only to debt. Preferred stock, if present, is added as (P/V) × Rp with no (1 − T) factor.

Extended formula:

WACC = (E/V) × Re + (P/V) × Rp + (D/V) × Rd × (1 − T)

Every input in that line was defined in sections 3.1 and 3.2. This section puts them in one cell, shows a full numeric build, and then uses the rate in two jobs: discounting a DCF and gating a project.

Full Numeric Build — Meridian Packaging

Meridian Packaging is a taxable U.S. corporation. The case gives:

• Market capitalization E = $600 million
• Market value of interest-bearing debt D = $400 million
• No preferred
• V = $1,000 million
• Re = 10.0% (already computed from CAPM: Rf + β × ERP)
• Rd = 6.0% (YTM on Meridian's senior notes; the coupon is 5.0%)
• T = 25%

Weights: E/V = 600/1,000 = 0.60, D/V = 400/1,000 = 0.40.

After-tax cost of debt = 6.0% × (1 − 0.25) = 6.0% × 0.75 = 4.50%.

WACC = (0.60 × 10.0%) + (0.40 × 4.50%) = 6.00% + 1.80% = 7.80%

If you had used the coupon of 5.0% instead of the YTM of 6.0%, after-tax debt cost would be 3.75% and WACC would print 6.00% + 1.50% = 7.50% — 30 basis points too low, which would overstate DCF value. Coupons are history. YTM is the rate a new lender would require today on a similar claim, which is the opportunity-cost definition of Rd.

Book equity is $310 million and book debt is $380 million. Book weights of 45% / 55% with the same Re and after-tax Rd would print WACC = 0.45 × 10.0% + 0.55 × 4.50% = 6.98%. That is not Meridian's cost of capital. Investors cannot buy the equity at book.

Adding Preferred

Now add preferred. Suppose Meridian also has preferred with market value P = $100 million and Rp = 8.0% (preferred dividend divided by the preferred's market price). Then V = 600 + 400 + 100 = $1,100 million.

WACC = (600/1,100) × 10.0% + (100/1,100) × 8.0% + (400/1,100) × 6.0% × (1 − 0.25) = 0.5455 × 10.0% + 0.0909 × 8.0% + 0.3636 × 4.50% = 5.455% + 0.727% + 1.636% = 7.82%

The preferred slice is not multiplied by (1 − T). If a candidate applies the tax shield to preferred, that slice becomes 0.0909 × 8.0% × 0.75 = 0.545% and WACC prints 7.64% — understated. Preferred dividends are not deductible.

What WACC Discounts

WACC is the discount rate for unlevered free cash flow (UFCF) — also called free cash flow to the firm (FCFF). UFCF is cash generated by operations after tax as if the firm had no debt, before interest. Discounting the UFCF forecast, including terminal value, at WACC produces enterprise value (EV). Equity value is then EV minus net debt (and minus preferred and non-controlling interest when those claims were not already treated consistently in the WACC stack).

CFI's standard DCF is nominal FCF with nominal WACC. If your revenue forecast grows with an inflation assumption, Rf in CAPM should be a nominal Treasury yield, and Rd should be a nominal YTM. Mixing real cash flows with a nominal WACC understates value; mixing nominal cash flows with a real (inflation-stripped) WACC overstates value. Pick one world and stay in it.

Mid-year convention, stub periods, and terminal-value mechanics belong in the DCF chapters. The cost-of-capital point is simpler: the rate and the cash flows must live in the same inflation world and the same leverage world. You do not discount UFCF at Re, and you do not discount FCFE at WACC.

WACC as a Hurdle, and Why the Cell Is Less Precise Than It Looks

The pie chart is Meridian's 7.80% in contributions, not in market-value weights: the equity slice contributes 6.00 percentage points of WACC and the after-tax debt slice contributes 1.80. Weights were 60/40; contributions are not 60/40 because Re and after-tax Rd are not equal.

Hurdle-Rate Decision Rule

Outside a full DCF of the firm, WACC is the hurdle rate for projects that have the same risk and the same financing mix as the firm. The rule is the same NPV/IRR logic from the capital-budgeting chapter, now with an explicit rate:

• If project NPV > 0 when cash flows are discounted at WACC, the project earns more than capital providers require — accept.
• If project IRR < WACC, do not invest. The firm creates more value by returning cash to claimholders (share repurchase or dividend) or by paying down costly claims than by taking a sub-WACC project.

A project that is riskier than the firm's existing assets (a new country, a new product with higher operating leverage) needs a higher hurdle than firm WACC — typically via a higher beta in Re, not by arbitrarily adding a "fudge factor" to Rd. A project that will be financed with a different mix (for example, a ring-fenced project-finance vehicle) needs its own weights, not the parent WACC copied blindly.

Worked hurdle example. Meridian WACC is 7.80%. A packaging-line expansion requires $50 million today and is forecast to return cash with an IRR of 7.10%. NPV at 7.80% is −$4.2 million. The expansion should be rejected. Using the unused $50 million to repurchase shares, or to pay a dividend, leaves claimholders with capital they can reinvest at their required returns. Forcing the 7.10% project destroys $4.2 million of enterprise value. "But 7.10% is positive" is not the test; the test is 7.10% versus 7.80%.

If a second project has IRR of 9.40% and NPV of +$6.1 million at 7.80%, and the risk and financing mix match the firm, accept. The extra 160 basis points over WACC is value created for the blended claimholders.

Limitations — Inputs Are Hard to Measure

WACC looks precise to two decimal places in a model. The inputs are not:

• Rf moves every trading day. There is no official FMVA Treasury yield. You pick a liquid long-term government yield in the same currency as the cash flows and you document the date. This guide will not invent a current 10-year print and call it "the" Rf.
• ERP is a research choice. Kroll/Morningstar publications are a common institutional source; different vintages and different country premia change Re by tens of basis points, sometimes more than 100.
• Beta is estimated, not observed. Window length, return frequency, peer set, and the D/E used to relever all move βL, and therefore Re.
• Rd should be YTM, but private firms have no traded bonds. Analysts then use a synthetic rating and a yield curve, which is another estimate. Using the coupon because it is "known" is still wrong.
• Tax rate T should be the marginal rate at which incremental interest is deductible. A firm with net operating losses, or in a jurisdiction that limits interest deductibility, does not get the full (1 − T) shield. Using the effective tax rate from last year's income statement can understate or overstate the shield.
• Weights require a target mix. The current mix may be a one-quarter accident; the stated target may be aspirational. Either way, E and D must still be market values.

Because of this, professional models often show WACC to one decimal place, or they use a round hurdle (8% rather than 7.83%), and then run sensitivity on WACC in a data table. A DCF that swings $400 million of EV when WACC moves 50 basis points should not be presented as a single-point "the" value. Scenario and sensitivity chapters will build those tables; the cost-of-capital lesson is that a brittle WACC is a model risk, not a badge of precision.

Integrity Checklist for an FMVA-Style WACC

1. E and D (and P) are market values, never book equity or face value when a market price exists.
2. Rd is YTM on existing debt of similar risk, not the coupon.
3. The tax shield is on debt only. Preferred is (P/V) × Rp with no (1 − T).
4. Re comes from CAPM with a relevered beta at the same target D/E used in the weights.
5. WACC discounts UFCF to enterprise value. FCFE uses Re.
6. Nominal cash flows pair with a nominal WACC; real with real.
7. Project hurdle: IRR < WACC → do not invest; returning cash via buyback or dividend can be the better use of capital.
8. Do not invent a live Treasury print as a universal Rf. Use the case rate, or look up and date-stamp a 10-year yield on a live model.

Those eight points are the cost-of-capital spine of CFI's DCF Valuation Modeling Fundamentals and Applied DCF courses. They show up as conceptual items and as Excel case-study cells on the FMVA final. Get the pairing right and the arithmetic is ordinary weighted-average math. Get the pairing wrong and a clean-looking 7.80% still values the wrong cash flow.