Weighted average cost of capital

A firm funded by both debt and equity pays a different price for each. Blend them by their weights and you get the single number that values the whole firm: the weighted average cost of capital.

The weighted average cost of capital is a firm's overall cost of capital, calculated by combining the cost of its debt and the cost of its equity, each weighted by its proportion in the firm's financing. It represents the blended return the firm must earn to satisfy all its providers of capital, and it is the standard discount rate for valuing the firm as a whole.

Blending debt and equity

A firm typically raises money from two sources with different costs: debt, which is cheaper because it is less risky to the provider and its interest is often tax-deductible, and equity, which is more expensive because shareholders bear more risk and demand a higher return. The weighted average cost of capital combines these by weighting each cost by its share of the firm's total financing, producing a single rate that reflects the firm's actual funding mix. It is, in effect, the average price the firm pays for all its capital.

Why the mix matters

Because debt is usually cheaper than equity, the financing mix affects the weighted average cost of capital, and this connects to capital structure decisions. Adding cheaper debt can lower the average cost of capital, up to a point, which is part of the appeal of borrowing. But more debt also raises the risk of financial distress and makes both debt and equity riskier and so more costly, which eventually pushes the average back up. The interplay means there is, in theory, a financing mix that minimises the weighted average cost of capital, though locating it is far from straightforward.

Uses and limits

The weighted average cost of capital is widely used as the discount rate in valuing a firm and appraising investments of average risk. But it must be used carefully. It is appropriate only for projects of similar risk to the firm as a whole; applying it to a project of very different risk misleads. Its components, especially the cost of equity, are estimates resting on uncertain assumptions, so the resulting figure is approximate. And it shifts as the financing mix, market conditions, and risk change, so it is not a fixed constant.

The weighted average cost of capital is the workhorse discount rate of corporate finance, the single number that captures what a firm must earn across all its sources of funding. It ties together the cost of debt, the cost of equity, and the capital structure into one rate for valuing the firm and judging its investments, a powerful synthesis whose reliability depends entirely on the quality of the estimates and the appropriateness of applying a firm-wide average to the case at hand.