Weighted Average Cost of Capital (WACC)
Weighted Average Cost of Capital (WACC) is the blended rate of return that a company must earn on its overall asset base to satisfy all its capital providers—equity shareholders and debt holders—proportionally weighted by the market value of each component of the capital structure.
WACC is the most commonly used discount rate in DCF valuation models and serves as the benchmark hurdle rate for corporate investment decisions. If a project's expected return exceeds the WACC, it creates value for shareholders; if it falls below WACC, it destroys value.
The formula for WACC is: WACC = (E/V × Re) + (D/V × Rd × (1 − Tax Rate)), where E is the market value of equity, D is the market value of debt, V = E + D is the total firm value, Re is the cost of equity, and Rd is the pre-tax cost of debt. The (1 − Tax Rate) term on the debt component reflects the tax shield: since interest payments are tax-deductible in India, debt is cheaper than equity on an after-tax basis.
The cost of equity is typically estimated using the Capital Asset Pricing Model (CAPM): Re = Risk-Free Rate + Beta × Equity Risk Premium. In the Indian context, the risk-free rate is usually proxied by the 10-year Government of India bond yield, which has ranged between 6% and 8% in recent years. The Equity Risk Premium for India is typically estimated at 4–7% above the risk-free rate to compensate for the additional uncertainty of equity ownership. A company with a beta of 1.2 and using a 7% risk-free rate and 5% ERP would have a cost of equity of 7% + 1.2 × 5% = 13%.
For capital-intensive Indian companies in infrastructure, real estate, or manufacturing, the capital structure often includes a mix of rupee-denominated loans, external commercial borrowings (ECBs), and non-convertible debentures. Each component is weighted and blended. Tax rate used is typically the effective tax rate rather than the statutory rate.
Changes in WACC have a disproportionate impact on valuations. When the RBI cuts the repo rate, G-sec yields fall, the risk-free rate drops, and WACC declines, mechanically boosting DCF valuations—which is one reason equity markets often rally in rate-cut cycles.