Why does adding debt lower WACC?

On the arithmetic here, because debt is cheaper and deductible. In practice the cost of equity rises as leverage grows, so the real curve turns back up. Treat a very low WACC from heavy debt with suspicion.

Businessvaluation

WACC Calculator

The blended rate a business pays for its capital, and the usual discount rate in a valuation. Debt looks cheap partly because interest is deductible, and the tax shield is shown separately so that is visible.

Also called: weighted average cost of capital calculator, discount rate calculator.

Weighted average cost of capital

9.44%

9.44%. Equity is 60% of the capital at 12%, and debt is 40% at an after-tax 5.6%. The tax shield is worth 0.96% points.

Equity weight

60%

Debt weight

40%

After-tax cost of debt

5.6%

Points saved by the tax shield

0.96%

Total capital

$1,000,000,000.00

How this is calculated

An estimate, not an offer or a guarantee. Projected returns assume the rate you entered holds for the whole term, which no market does.

Method and background

How this is calculated

Weight each source of capital by its market value and multiply by what it costs. Interest is deductible, so the effective cost of debt is the rate times one minus the tax rate, which is why heavily indebted firms show a low WACC. The weights should be market values rather than book values, because the question is what capital costs now and not what it cost when it was raised.

WACC = equity share * cost of equity + debt share * cost of debt * (1 - tax rate)

E: Market value of equity (currency)
D: Market value of debt (currency)
r_e: Cost of equity (decimal)
r_d: Cost of debt before tax (decimal)
t: Corporate tax rate (decimal)

Worked examples

Each of these is asserted on every build. If a change to the engine ever moved one of these answers, the build would fail before the page could print it.

sixty forty at twelve and eight

Market value of equity: $600.00
Market value of debt: $400.00
Cost of equity: 12%
Cost of debt, before tax: 8%
Corporate tax rate: 30%

Weighted average cost of capital9.44%

0.6*12 + 0.4*8*0.7, worked by hand

Open this example

all equity is just the cost of equity

Market value of equity: $1,000.00
Market value of debt: $0.00
Cost of equity: 12%
Cost of debt, before tax: 8%
Corporate tax rate: 30%

Weighted average cost of capital12%

boundary

Open this example

no tax removes the shield entirely

Market value of equity: $600.00
Market value of debt: $400.00
Cost of equity: 12%
Cost of debt, before tax: 8%
Corporate tax rate: 0%

Weighted average cost of capital10.4%

degenerate case: after-tax cost of debt equals the pre-tax cost

Open this example

Method and limits

What it assumes

The capital structure is stable. A changing mix means a changing WACC.
The tax rate is the marginal rate on interest, not the accounting effective rate.

What it deliberately does not model

It does not account for the rising cost of equity as leverage grows, so it can be pushed to an artificially low number by assuming more debt.
Preference shares and convertibles are separate components not modelled here.

Formula version 1.0.0 · definition 1.0.0 · United States · Report a problem with this calculator

Frequently asked questions

Why does adding debt lower WACC?: On the arithmetic here, because debt is cheaper and deductible. In practice the cost of equity rises as leverage grows, so the real curve turns back up. Treat a very low WACC from heavy debt with suspicion.