Cost of Equity and WACC: How They Fit Together
Where cost of equity sits in the WACC formula, a worked example that lands at 8.5%, market vs book weights, and when to discount with Ke instead of WACC.
By the CostOfEquityCalculator.com team
Cost of equity is one of two main ingredients in the weighted average cost of capital (WACC). WACC blends the cost of equity and the after-tax cost of debt, weighted by how much of each the company uses. With $600 of equity, $400 of debt, an 11% cost of equity, a 6% pre-tax cost of debt and a 21% tax rate, WACC is about 8.5%.
You can get the cost of equity from any tab of the cost of equity calculator, then bring it into the formula below. This guide shows how the pieces fit, which weights to use, and when you should use cost of equity on its own instead.
The WACC formula
WACC = E/V x Ke + D/V x Kd x (1 - t)- E is the market value of equity.
- D is the market value of debt.
- V is E + D, the total value of the company’s capital.
- Ke is the cost of equity.
- Kd is the pre-tax cost of debt.
- t is the tax rate.
The cost of equity covers shareholders. The cost of debt covers lenders. WACC is the blended return the company has to earn on its assets to satisfy both.
The (1 - t) term only applies to debt. Interest is tax deductible, so the company’s real cost of borrowing is lower than the rate it pays. Dividends get no such deduction, which is why there’s no tax adjustment on Ke. The guide on cost of equity vs cost of debt explains that difference in more detail.
Worked example
Inputs:
| Input | Value |
|---|---|
| Market value of equity (E) | $600 |
| Market value of debt (D) | $400 |
| Cost of equity (Ke) | 11% |
| Pre-tax cost of debt (Kd) | 6% |
| Tax rate (t) | 21% |
The 11% cost of equity comes from the site’s CAPM example: 5% risk-free rate plus 1.2 beta times a 5% equity risk premium. The 21% tax rate is the US federal corporate rate.
Step 1. Total capital: $600 + $400 = $1,000.
Step 2. Weights: equity is $600 / $1,000 = 60%, debt is $400 / $1,000 = 40%.
Step 3. After-tax cost of debt: 6% x (1 - 0.21) = 6% x 0.79 = 4.74%.
Step 4. Weighted equity: 60% x 11% = 6.60%.
Step 5. Weighted debt: 40% x 4.74% = 1.896%.
Step 6. Add them: 6.60% + 1.896% = 8.496%, or about 8.5%.
| Component | Weight | Cost | Weighted cost |
|---|---|---|---|
| Equity | 60% | 11.00% | 6.600% |
| Debt (after tax) | 40% | 4.74% | 1.896% |
| WACC | 100% | 8.496% |
Equity makes up 60% of the capital but more than three quarters of the WACC (6.6 of 8.496 points). That’s typical. Because equity is the more expensive source, the cost of equity estimate usually drives the result.
Market weights vs book weights
The weights should be based on market values. Book values from the balance sheet reflect historical accounting, which often has little to do with what the equity is worth today. The FAQ on whether you can find cost of equity on the balance sheet covers a related point.
For a listed company, market value of equity is share price times shares outstanding. For debt, book value is often used as a stand-in when the company’s debt trades near face value.
Here’s what happens if you use book equity by mistake. Say the same company’s balance sheet shows $300 of equity and the same $400 of debt:
| Market weights | Book weights | |
|---|---|---|
| Equity | $600 (60%) | $300 (42.9%) |
| Debt | $400 (40%) | $400 (57.1%) |
| WACC | 8.50% | 7.42% |
Using book weights cuts WACC by more than a point, because it gives too much weight to the cheaper source. That would push a valuation up for no good reason.
For private companies there’s no market price. Analysts often use a target capital structure, such as the industry’s average debt-to-equity ratio, or solve for it iteratively alongside the valuation.
Consistency between beta and weights
Your cost of equity and your WACC weights need to describe the same capital structure. If you relevered beta at a 0.5 debt-to-equity ratio (as in the levered vs unlevered beta guide), your WACC should use a 0.5 D/E too. That’s 1/3 debt and 2/3 equity.
The site’s main example uses a 1.2 beta with 60/40 weights. If you were relevering from scratch for a 60/40 company, D/E would be 400 / 600 = 0.667, and you’d relever beta at that ratio. Mixing a beta from one capital structure with weights from another is one of the most common WACC errors.
When to discount with Ke vs WACC
The rate has to match the cash flows. Cash flows that belong only to shareholders get discounted at the cost of equity. Cash flows that belong to everyone who funds the company get discounted at WACC.
| Free cash flow to equity (FCFE) | Free cash flow to the firm (FCFF) | |
|---|---|---|
| Who the cash belongs to | Shareholders only | Shareholders and lenders |
| Interest and debt repayments | Already subtracted | Not subtracted |
| Discount rate | Cost of equity | WACC |
| Result | Value of equity | Enterprise value (subtract debt to get equity) |
Done carefully, both approaches should land near the same equity value. In practice they rarely match exactly because of the assumptions involved.
Cost of equity on its own is also the natural choice for banks and other financial companies, where borrowed money is the raw material the business lends out. The FAQ on cost of equity for banks explains why.
How the two numbers relate
For a company with debt, WACC is almost always lower than cost of equity, because it blends in cheaper after-tax debt. For a company with no debt, the two are equal. The FAQ on whether cost of equity can be lower than WACC covers the rare exceptions, and the one on whether cost of equity is the same as WACC covers the basic difference.
Adding debt lowers WACC at first, because debt is cheaper. It also raises the cost of equity, because shareholders now carry more risk. Past a certain point, the rising cost of equity and rising cost of debt outweigh the cheaper financing. That trade-off is why most companies don’t fund themselves entirely with debt.
Using WACC
WACC is commonly used as the discount rate in a discounted cash flow valuation and as a hurdle rate for projects with the same risk as the company as a whole. A project that earns more than 8.5% in this example adds value. One that earns less destroys it.
If you want the whole calculation in a spreadsheet, the Excel guide has the WACC formula as a single cell. The methodology page lists the assumptions behind the calculator.
Frequently asked questions
Do I include short-term debt in the WACC weights?
Include interest-bearing debt of any maturity, such as bank loans, bonds and the current portion of long-term debt. Operating items like accounts payable are usually left out because they are handled in the cash flow forecast instead.
How do leases affect WACC?
Under current accounting rules many leases appear on the balance sheet as liabilities, and many analysts treat them as debt in the WACC weights. If you do, make sure the cash flows you discount are adjusted to match, so the lease payments are not counted twice.
What if a company has preferred stock?
Add it as a third component with its own weight and cost. The cost of preferred stock is usually its annual dividend divided by its price, with no tax adjustment because preferred dividends are not tax deductible.