When valuing a company using the discounted cash flow (DCF) method, two questions are key: How much cash will the company generate in the future, and what is that worth today? To answer the second question, you use the discount rate, better known as the WACC. In this blog, you’ll learn what WACC is, how to calculate it, and why this figure can make or break the outcome of your valuation.
What exactly is WACC?
WACC stands for Weighted Average Cost of Capital. It is the weighted average of the cost of equity and the cost of debt. Neither of these sources of capital is free: shareholders expect a return, and banks charge interest. WACC combines these into a single percentage rate that you use to discount future cash flows.
A higher WACC means that future earnings are worth less today, which results in a lower enterprise value. A lower WACC has the exact opposite effect.
How do you calculate the WACC?
The calculation combines the cost of equity and the cost of debt. In formula form:
WACC = (E/V × Re) + (D/V × Rd × (1 – tax rate))
Where:
- E = equity
- D = debt
- V = total power (E + D)
- Re = shareholders' return requirement
- Rd = interest on debt
The tax effect makes debt financing relatively cheaper, because interest is tax-deductible.
How do you determine the required return on equity?
The Capital Asset Pricing Model (CAPM) is typically used to calculate the cost of equity:
Risk-free interest rate + beta × market risk premium
- The risk-free interest rate is often derived from government bonds.
- The market risk premium reflects the additional return that investors demand for equity risk.
- The beta indicates how risky a company is relative to the market.
For small and medium-sized businesses, surcharges are often added to these rates, for example, based on company size or dependence on a few key customers.
What does this mean in practice for small and medium-sized businesses?
In practice, WACC rates for SME valuations often range from 10% to 18%. Companies with stable contracts, a diversified customer base, and tangible assets may have rates closer to 9–10%. Younger or higher-risk companies are more likely to have rates in the 15–18% range.
A difference of one or two percent may seem small, but it can make a difference of tons or even millions in the valuation.
Example:
Suppose a company generates €1 million in free cash flow per year.
- With a WACC of 10%, the value is roughly €10 million.
- With a WACC of 15%, the value drops to approximately €6.7 million.
This illustrates just how crucial it is to choose a realistic WACC.
Frequently Asked Questions
Who determines the WACC?
There is no official WACC. Advisors determine it based on market data, industry, and company characteristics.
Why do investors often use a higher WACC?
Because they assess risks more strictly. What feels familiar to you may be uncertain to them.
Is a lower WACC always better?
For your valuation, yes, but it has to be realistic. A WACC that’s too low undermines your credibility.
Would you like to know what a realistic WACC is for your company and what that means for its value? Contact Hogenhouck M&A. We provide clarity on risks and returns, so you can negotiate from a position of strength with buyers or investors.
