WACC (Weighted Average Cost of Capital)
Definition
WACC is the blended required return of all a company's capital providers, weighted by their share of the capital structure at market values: WACC = (E/V) x cost of equity + (D/V) x cost of debt x (1 − tax rate), where E is equity value, D is debt, and V = E + D (a preferred stock term, weighted at its cost with no tax adjustment, is added if applicable).
The cost of debt is tax-adjusted because interest is tax-deductible (subject to jurisdictional limits) — this is where the DCF captures the debt tax shield, since unlevered FCF ignores interest. Weights should use target or market-value capital structure, not book values.
WACC is the discount rate for unlevered free cash flows: it represents the opportunity cost of capital for the business's overall risk. Higher WACC means lower present value.
Why interviewers ask
"Walk me through WACC" and "what happens to WACC as you add debt?" (initially falls because debt is cheaper and tax-shielded, then rises as financial distress risk pushes up both cost of debt and cost of equity — a U-shape) are guaranteed. Traps: using book-value weights, forgetting the (1 − t) on debt only, and discounting levered cash flows at WACC.
Related terms
Interviews don't test definitions — they test recall under pressure.
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