The Cost of Capital (WACC)#

In the DCF model, we need a rate "r" to discount future cash flows. This rate is the Cost of Capital. It represents the "hurdle rate"—the minimum return a company must earn to satisfy its investors.

Most often, we use the Weighted Average Cost of Capital (WACC).

The "Blended Smoothie" Analogy#

Think of WACC like making a smoothie using two ingredients:

Debt (Loans): This ingredient is cheap but risky if you consume too much (bankruptcy).
Equity (Stocks): This ingredient is expensive (shareholders demand high returns) but safe (no mandatory payments).

WACC is the taste of the final smoothie. If you use 80% Equity and 20% Debt, the smoothie tastes mostly like Equity.

The WACC Formula#

Weighted Average Cost of Capital

WACC = \frac{E}{V} \times R_e + \frac{D}{V} \times R_d \times (1 - T)

Where

E/V=Percentage of Equity in capital structure

D/V=Percentage of Debt in capital structure

R_e=Cost of Equity

R_d=Cost of Debt

T=Corporate Tax Rate

1. Cost of Debt (Rd)#

This is easy. It's the interest rate the company pays on its loans.

The Tax Shield: Notice the (1 - T). Interest payments are tax-deductible! The government effectively gives you a coupon for debt. If your interest rate is 5% and tax rate is 20%, your real cost of debt is only 4%.

2. Cost of Equity (Re)#

This is harder. Equity investors don't send you a bill. But they do expect a return. If they don't get it, they sell the stock. We use the Capital Asset Pricing Model (CAPM) to estimate this expectation.

Cost of Equity (CAPM)

R_e = R_f + \beta \times (R_m - R_f)

Where

R_e=Cost of Equity

R_f=Risk-Free Rate (e.g., 10-Year Treasury)

β=Beta (volatility vs. market)

R_m - R_f=Equity Risk Premium (~5%)

Risk Free Rate: The baseline. Usually the 10-Year US Treasury Yield (e.g., 4%).
Equity Risk Premium (ERP): The "Hazard Pay" for buying stocks instead of safe bonds (historically ~5%).
Beta: The volatility multiplier.
- Utility Co (Beta 0.5): Safe. Cost of Equity = 4% + 0.5 * 5% = 6.5%.
- Tech Startup (Beta 2.0): Risky. Cost of Equity = 4% + 2.0 * 5% = 14%.

Putting it Together#

If you are valuing that risky Tech Startup, your WACC will be high (maybe 12-15%).

High WACC = High Discounting. Future cash flows are worth very little today because the risk is so high.
Low WACC = Low Discounting. Future cash flows are valuable today (like a steady utility company).

Key Takeaways

WACC is the blended cost of a company's funding (Debt + Equity). - Debt is cheaper than equity because of the tax shield and lower risk profile. - Cost of Equity is calculated using CAPM (Risk Free Rate + Beta * Risk Premium). - Higher risk (higher Beta) leads to a higher WACC, which lowers the company's valuation.