Last Updated: August 19, 2026
|Publish Date: August 19, 2026
A full WACC build, from risk-free rate to final figure — then the same company run through CAPM and the build-up method, showing why private company valuations use a different rate.
The weighted average cost of capital is the return a company must generate to satisfy everyone who funds it — lenders and shareholders together — with each group weighted by how much of the funding it provides.
In valuation it does one job: it is the rate at which future cash flows are discounted to present value. That makes it the single most influential assumption in most valuation models, and the one reviewers examine first.
The WACC Formula
WACC = (E/V × Re) + (D/V × Rd × (1 − T))
Component | Meaning | Typical source |
|---|---|---|
E/V | Equity as a share of total capital | Target or observed capital structure |
Re | Cost of equity | CAPM, or the build-up method |
D/V | Debt as a share of total capital | Target or observed capital structure |
Rd | Pre-tax cost of debt | Actual borrowing rate, or a synthetic rating |
T | Tax rate | Marginal rate, not the effective rate |
Debt appears cheaper than equity for two reasons: lenders rank ahead of shareholders and therefore accept a lower return, and interest is generally tax deductible while dividends are not.
Why WACC Matters
WACC is the discount rate in a discounted cash flow model. Change it by a single percentage point and the valuation moves by roughly ten percent — a point demonstrated with figures later in this article.
It is also the hurdle rate for investment decisions. A project expected to return less than WACC destroys value even if it is profitable in accounting terms, because the capital funding it could have earned more elsewhere.
A Worked WACC Calculation
The following builds WACC for a private manufacturer with $20 million of revenue.
Step 1: Cost of Equity Using CAPM
Input | Source | Value |
|---|---|---|
Risk-free rate | 20-year government bond | 4.5% |
Equity risk premium | Long-run market premium | 5.5% |
Beta | Relevered from comparable companies | 1.2 |
Size premium | Small company adjustment | 2.4% |
Cost of equity | 4.5% + (1.2 × 5.5%) + 2.4% | 13.5% |
Step 2: Cost of Debt
Input | Value |
|---|---|
Pre-tax borrowing rate | 8.0% |
Tax rate | 25% |
After-tax cost of debt | 8.0% × (1 − 0.25) = 6.0% |
Use the marginal tax rate, not the effective rate from the accounts. The effective rate reflects prior-year timing differences and credits that will not recur.
Step 3: Weight and Combine
Component | Weight | Cost | Contribution |
|---|---|---|---|
Equity | 80% | 13.5% | 10.80% |
Debt | 20% | 6.0% | 1.20% |
WACC | 100% | 12.00% |
The Build-Up Method: Where Private Company Valuation Differs
CAPM depends on beta, and beta is derived from observed share price movements. A private company has no share price, so beta must be borrowed from public comparables — companies that are larger, more diversified and more liquid than the subject.
Private company valuation therefore commonly uses the build-up method, which constructs the cost of equity from observable risk premiums rather than a borrowed beta.
Component | Meaning | Value |
|---|---|---|
Risk-free rate | Long-dated government bond | 4.5% |
Equity risk premium | Return over risk-free for equity generally | 5.5% |
Size premium | Smaller companies fail more often and raise capital on worse terms | 2.4% |
Industry risk premium | Sector-specific volatility above the market | 1.0% |
Company-specific risk premium | Customer concentration, key person dependence, thin management | 2.0% |
Cost of equity | 15.4% |
Applying the same 80/20 capital structure:
WACC = (0.80 × 15.4%) + (0.20 × 6.0%) = 13.52%
The Two Methods Compared
CAPM | Build-up | |
|---|---|---|
Cost of equity | 13.5% | 15.4% |
WACC | 12.00% | 13.52% |
Beta required | Yes | No |
Company-specific risk captured | No | Yes |
Best suited to | Companies with close public comparables | Private companies, closely held businesses |
Common in | Corporate finance, public markets | 409A, purchase price allocation, gift and estate, disputes |
The build-up figure is 1.52 percentage points higher. That is not a discrepancy to be reconciled. It reflects risks a borrowed public-company beta does not capture. The size discount valuation practitioners apply to smaller businesses is the same idea, expressed through the discount rate rather than as a deduction from value.
What One Percentage Point Does
Applying both rates to the same five-year cash flow forecast — $3.0M, $3.9M, $4.8M, $5.6M and $6.3M, with terminal growth of 2.5%:
Discount rate applied | Enterprise value |
|---|---|
WACC 12.00% (CAPM) | $54.9M |
WACC 13.00% | $49.3M |
WACC 13.52% (build-up) | $46.7M |
The gap between the two methods is $8.2 million, or 15% of value. Each single percentage point of WACC moves enterprise value by roughly $5.4 million — close to 10%.
Neither analyst made an arithmetic error. They applied different methods to a company that only one of the two methods genuinely fits. This is why the choice of method is disclosed and defended in a professional report rather than assumed.
Unlevering and Relevering Beta
Where CAPM is used, the beta observed in comparable companies reflects their capital structures, not the subject's. It has to be stripped of that leverage and rebuilt at the subject's target structure.
Unlevered beta = Levered beta ÷ [1 + (1 − T) × D/E]
With a comparable levered beta of 1.35, a comparable D/E of 0.35 and a 25% tax rate:
1.35 ÷ [1 + (0.75 × 0.35)] = 1.07
Relevering at the subject's target D/E of 0.25:
1.07 × [1 + (0.75 × 0.25)] = 1.27
Skipping this step and using a comparable's raw beta imports that company's financing decisions into the subject's valuation.
Target Capital Structure vs Actual
WACC weights should generally reflect the capital structure the business is expected to maintain, not a temporary position on the valuation date.
Situation | Which structure to use |
|---|---|
Stable, sustainable leverage | Actual |
Temporarily high debt after an acquisition | Target |
Temporarily low debt after a raise | Target |
Industry norm differs materially from actual | Industry median, with reasoning stated |
Weights should also be based on market values, not book values. Book equity is a historical accounting figure and rarely reflects what the equity is worth.
When WACC Is Not the Right Rate
Situation | Use instead |
|---|---|
Discounting free cash flow to equity | Cost of equity alone |
Valuing a specific project riskier than the firm | A project-specific rate |
The business holds assets rather than generating cash | The asset approach |
Capital structure changes materially over the forecast | Adjusted present value |
The most common error is discounting free cash flow to the firm at the cost of equity, or free cash flow to equity at WACC. Each cash flow measure pairs with exactly one rate, and mismatching them produces a figure that means nothing.
What Reviewers Challenge
A WACC submitted for audit, tax or transaction purposes is tested component by component. Reviewers typically ask:
Which comparable companies supplied the beta, and why that set
Whether beta was unlevered and relevered, and at what capital structure
What supports the size premium, and which study it comes from
What supports any company-specific risk premium — this attracts the most scrutiny, because it is the least observable
Whether the tax rate is marginal or effective
Whether weights use market values or book values
In a purchase price allocation, whether WACC has been reconciled against WARA and the deal IRR
The company-specific risk premium is where most challenge lands. A 2% addition with no stated basis is an assertion. The same 2% supported by documented customer concentration, key person dependence or forecast volatility is an opinion a reviewer can test. That distinction usually decides whether a WACC survives review or gets renegotiated.