At its core, WACC balances two sources of financing:

• Equity: owners of the business expect a return that reflects their opportunity cost and risk exposure;

• Debt: lenders require interest payments, but because these payments are tax-deductible, we adjust the cost of debt downward to reflect the tax shield.

Each source has its own required rate of return and a proportion of total financing. WACC blends them using this formula:

$\text{WACC} = \left( \frac{E}{V} \times \text{Cost of Equity} \right) + \left( \frac{D}{V} \times \text{Cost of Debt} \times (1 - \text{Tax Rate}) \right)$

Where:

• $E$ - market value of equity;

• $D$ - market value of debt;

• $V = E + D$ (total capital).

Understanding each component:

• Cost of Equity often comes from the CAPM formula. It reflects investor expectations based on risk;

• Cost of Debt is based on the interest rate the firm pays, adjusted for tax savings;

• Tax Rate reduces the effective cost of debt due to deductibility;

• Capital Weights (E/V and D/V) should reflect current market values, not accounting book values, for the most accurate picture.

A company with more debt benefits from tax shields but takes on more financial risk. A company with more equity may pay a higher cost (as investors expect greater returns), but it gains flexibility.

WACC plays a critical role in determining whether a project or investment adds value. If the expected return on a project is greater than WACC, it likely creates shareholder value. If it's below WACC, the company is better off walking away.