WACC · Weighted Average Cost of Capital
Weighted Average Cost of Capital
What is WACC?
- Weighted average of equity and debt costs
- The minimum bar for investment decisions, and the discount rate
- It is sensitive to assumptions, so present it as a range
Once you calculate WACC properly, investment meetings change. Before, “this one looks fine” was a matter of experience and intuition. Afterward, a single line, 9.4%, sits on the table. A project with impressive revenue is rejected if it does not clear that line, and one with a modest return passes if it does. The real change is that the language of judgment shifts from “looks good” to “how many percentage points above the benchmark.” What matters more than the precision of the number is that a benchmark exists, and that alone clears up much of the organization’s wasteful debate.
The calculation itself is simple. Multiply the cost of debt by (1 − corporate tax rate). Build the cost of equity from the risk-free rate plus beta times the market risk premium. Then weight each by its share of the capital mix. The weights, however, must be based on market value and the target capital structure, not book value. For listed Korean manufacturers, WACC typically comes out at 7–10%, while unlisted small and mid-sized companies often reach double digits once a 2–4 percentage-point size premium is added. The hurdle rate is WACC plus a margin of safety set by management, so the two terms should not be used interchangeably.
At the application stage, you have to match the cash flow with the right discount rate. What you discount at WACC is free cash flow to the firm, which covers both creditors’ and shareholders’ shares. If you subtract interest expense or principal repayments from it again, you count the debt burden twice. Use nominal WACC for nominal cash flows that include inflation, and real WACC for real-terms figures. For overseas subsidiary projects, the currency basis must match as well, or the result is meaningless.
The most common failure in practice is applying a single company-wide WACC to every proposal. A risky new venture whose real required return is 15% gets discounted at 9%, which inflates its NPV, while a stable equipment replacement is undervalued and pushed back. Over time, only risky projects get approved and safe investments get rejected. Some companies are lured by the math that more debt lowers WACC, then take on too much, see their credit rating fall, and watch their cost of equity rise until WACC actually goes up. WACC is not a number to push down but a baseline to hold.
Okgum LeeExpert in company analysis, investment attraction, and business planning
Eunpyo HongExpert in company analysis, startups, and startup fundraisingAgainst the backdrop of Modigliani and Miller’s capital structure theory and the development of the Capital Asset Pricing Model (CAPM), weighting a company’s financing costs to set the benchmark for investment decisions became standard practice in corporate finance.
Company A, an auto parts maker with 240 employees and annual revenue of about KRW 90 (≈ US$1) billion, had spent six months unable to decide whether to put KRW 12 billion (≈ US$8,978,000) into a new production line. The sales division said, “A 9% return is enough.” The finance team countered, “At that level, we’d actually be losing money.” With no benchmark, every meeting circled back to the same place. (Hypothetical example)
- The CFO first reset the capital structure. The book debt ratio was 120%, but looking ahead three years, the CFO insisted on using the target structure of 40 debt to 60 equity as the basis.
- The head of finance collected new-loan terms from three of the company’s main banks and found an average rate of 5.2%. Applying the tax shield at a 22% corporate tax rate brought the after-tax cost of debt down to 4.1%.
- The cost of equity was estimated at 13.0%: a 3.4% 10-year government bond yield, plus a peer-company beta of 1.1 times a 6% market risk premium, plus a 3 percentage point size premium for an unlisted company. The weighted-average WACC came out at 9.4%.
- When the head of production asked, ‘Are you saying a project earning 9% is a loss?’, the CFO replied, ‘It means we can’t even cover what we paid for the capital,’ and put up a sensitivity table. Across a beta range of 0.9 to 1.3, WACC swung between 8.6% and 10.2%.
- Company A cut its expansion from KRW 12 billion (≈ US$8,978,000) to KRW 8 (≈ US$1) billion, keeping only the high-margin product line. The expected IRR rose from 9.1% to 13.6% and the project cleared investment review. From then on, a 9.4% hurdle rate was attached to every investment proposal.