How do you blend the cost of debt and equity into one discount rate?
When you value the whole firm (FCFF, remember), you're discounting cash that belongs to lenders and owners together — so your discount rate must reflect both their required returns, weighted by how much of the company each one funds. That blend is the weighted average cost of capital (WACC).
A weighted average, nothing fancier
WACC is exactly what it sounds like: take the cost of equity and the cost of debt, and average them in proportion to how much of the company each provides.
Suppose a company is funded 70% by equity at a required return of 10%, and 30% by debt at an after-tax cost of 4%:
- Equity contribution: 0.70 × 10% = 7.0%
- Debt contribution: 0.30 × 4% = 1.2%
- WACC ≈ 8.2%
That single 8.2% is the rate you'd use to discount firm-level free cash flow. It sits between the two costs, pulled toward whichever source finances more of the business.
Why debt lowers the average (and the trap in that)
Because debt is cheaper than equity, adding debt lowers the blended WACC — which, mechanically, raises a DCF value. It's tempting to conclude "more debt = more valuable." Resist it. More debt also makes the equity riskier, which pushes the cost of equity up and raises the odds of distress. The cheap-debt effect is real but self-limiting; a model that "creates value" purely by piling on leverage is fooling you.
Keep it honest, keep it round
WACC has an aura of precision it doesn't deserve — every input (cost of equity especially) is an estimate. Treat WACC as a reasonable band, say "around 8%," not "8.17%." In the final unit you'll see how a half-point change in this one number swings the whole valuation — which is precisely why pretending to know it to two decimals is dangerous.
In the data
The two weights come from two different kinds of number. The equity side is a live market value:
The debt side is book value at a fiscal year end, and there is more than one candidate for "debt":
Total debt, long-term debt, net debt and total liabilities are four different figures for the same company and date. Each produces a different weight and therefore a different WACC, and nothing on the balance sheet marks one of them as the intended one.
Try it now
- Compute the equity weight as market capitalisation ÷ (market capitalisation + debt), using total debt (short and long) as the debt. Is this business mostly equity-funded or debt-heavy?
- Now do it three more times, swapping in long-term debt, net debt, and total liabilities from the balance-sheet totals for the same year end:
Four weights, four WACCs, one company, one day — measure the spread between the highest and the lowest. That spread is what "the" WACC is worth without a stated choice of debt, and it is why the number you publish has to carry the choice you made beside it. 3. Using a plausible cost of equity (say 9–11%) and after-tax cost of debt (say 3–5%), blend them with your weights on paper. What single WACC do you get? Round it — "around 8%", never "8.17%". 4. Now nudge your cost of equity up by one point and re-blend. Notice how strongly WACC moves for an equity-heavy firm: in the 70/30 company above, the blend goes 8.2% → 8.9%, so 0.7 of your one point lands straight in the rate. A debt-heavy firm would barely register it. File away the rule — the sensitivity to the cost of equity is simply the equity weight.