Weighted average cost of capital (WACC) combines the required returns of a company’s financing providers. It is commonly the discount rate for operating cash flows available to both lenders and shareholders, rather than cash flows left only for shareholders.
For a company financed only by ordinary equity and debt: WACC = [E ÷ (E + D)] × Re + [D ÷ (E + D)] × Rd × (1 − T). E and D are market values of equity and interest-bearing debt, not accounting book values. Re is the cost of equity, Rd the current pre-tax cost of borrowing, and T the applicable marginal corporate tax rate.
The weights measure the financing mix and sum to one. The factor (1 − T) allows for the assumed tax saving from deductible interest. That tax shield requires usable deductions; losses or deduction limits can reduce or delay it. Preferred shares or other financing require additional matching components.
Example (illustrative): equity supplies 60% of market-value financing at an annual required return of 10%; debt supplies 40% at a pre-tax 5%; the usable marginal tax rate is 25%. After-tax debt cost is 5% × 0.75 = 3.75%. WACC = 0.60 × 10% + 0.40 × 3.75% = 7.5% per year.
This is a blended financing hurdle under those assumptions. It does not mean shareholders require only 7.5%: their assumed cost of equity remains 10%. Nor does it tell you what the company or its shares will earn.
Free cash flow to the firm (FCFF) is cash after operating taxes and reinvestment, before payments to financing providers. WACC commonly discounts this claim. Free cash flow to equity (FCFE) is the residual after debt interest, repayments and new borrowing are accounted for; it uses the cost of equity. A label such as free cash flow alone does not tell you which claim you have.
Match currency, inflation treatment and timing as well as business risk. Nominal cash flows include expected inflation; real cash flows remove it. A fixed WACC assumes sufficiently stable financing and risk. More debt does not automatically lower WACC because lenders and shareholders can require higher returns as financial risk rises. Negative cash flows do not make the formula invalid, but they require explicit future funding assumptions.
No. Cost of equity is the return required by shareholders. WACC combines financing-provider costs and commonly discounts cash flows available to both lenders and shareholders.
The weights represent the current economic financing mix. Accounting book values can describe a very different mix. A target mix needs explicit justification and consistent financing costs.
Only after checking the cash-flow definition. Reported operating cash flow can already reflect interest and financing-related taxes. That shorthand is not automatically FCFF.
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Educational research only — not investment advice.