Weighted Average Cost of Capital
Also known as: WACC, Cost of Capital
The weighted average cost of capital (WACC) is the blended rate a company pays to finance its operations across debt and equity, and it is the standard discount rate in a DCF.
The weighted average cost of capital, or WACC, is the average return a company must earn to satisfy all of its investors, both lenders and shareholders. It blends the cost of debt and the cost of equity, weighted by how much of each the company uses.
Why it is the discount rate
In a discounted cash flow, future cash flows are discounted at the WACC because it represents the opportunity cost of the capital tied up in the business. A higher WACC means investors demand more return for the risk, which lowers the present value of those future cash flows.
The components
The cost of debt is the after-tax interest rate the company pays on borrowing. The cost of equity is usually estimated with the capital asset pricing model, which builds up from a risk-free rate, the company’s beta, and an equity risk premium.