The weighted average cost of capital (WACC) is the blended after-tax cost of a company's capital structure, weighted by the market values of its debt and equity. It is the standard discount rate applied to unlevered free cash flow in a DCF valuation.
The formula
$ \text{WACC} = \frac{E}{V} \cdot r_E + \frac{D}{V} \cdot r_D \cdot (1 - t) $
Where:
- E = market value of equity
- D = market value of debt
- V = E + D
- rE = cost of equity
- rD = pre-tax cost of debt
- t = marginal corporate tax rate
The (1 − t) term reflects the tax shield on interest expense.
Cost of equity (CAPM)
The standard build is the Capital Asset Pricing Model:
rE = risk-free rate + β · equity risk premium
The risk-free rate is typically the 10-year US Treasury yield. The equity risk premium (ERP) is taken from a long-term study (Damodaran, Duff & Phelps / Kroll). Beta (β) is sourced from peers of comparable size and leverage, then re-levered to the target's capital structure. Private-company DCFs often layer on a size premium and sometimes a company-specific risk premium to reflect the smaller, less diversifiable risks of a single private business.
Cost of debt
The cost of debt is the yield to maturity on the company's existing debt, or — for a private target with little or no rated debt — the indicative coupon a lender would charge today, based on credit spread for the relevant rating and tenor.
Capital-structure weights
Weights should reflect a target capital structure — typically the long-run mix the business is expected to operate at, not necessarily its current snapshot. For lower-middle-market private-company DCFs, practitioners often anchor to the leverage of public-company peers.
Why it matters
WACC is the most sensitive single input in a private-company DCF. A 100 bps move in WACC can change implied enterprise value by 10–20% on a typical mid-life cash-flow profile. Practitioners therefore present WACC as a range (e.g. 11–13%) and report the resulting valuation as a range, never as a single point.
See also
- Discounted cash flow — An intrinsic valuation that discounts a company’s projected cash flows to present value.
- Terminal value — In a DCF, the present value attributed to all cash flows beyond the explicit forecast period — typically the largest single component of total value.
- Business valuation — The set of methods used to estimate the economic value of a company or its equity, almost always triangulated across several approaches into a defensible range.
- Enterprise value — The total value of a company’s operations, independent of its capital structure.