WACC
DCFThe blended cost of a company's debt and equity, weighted by their market values, used to discount unlevered cash flows.
Also written: weighted average cost of capital
WACC is what the business as a whole pays for capital. Because unlevered free cash flow is available to both lenders and shareholders, it must be discounted at a rate blending what both require, weighted by how much of the capital structure each provides.
Cost of equity comes from CAPM: the risk free rate plus beta times the equity risk premium. Cost of debt is what the company would pay to borrow today, not the coupon on debt issued years ago, and it is taken after tax because interest is deductible.
Both weights use market values, not book. You are pricing capital as it stands today, not recovering what it cost historically, and book equity in particular bears almost no relation to what shareholders actually require.
Debt is cheaper than equity twice over: lenders rank ahead so demand less, and the tax shield subsidises it further. That is the whole reason leverage lifts returns, and also why WACC does not simply fall forever as debt rises, since beyond some point the added financial risk raises both costs faster than the mix improves.
Worked example
Equity of 700 and debt of 300, so weights of 70% and 30%. A 3.0% risk free rate, 1.2 beta and 5.5% equity risk premium give a 9.6% cost of equity. A 5.0% pre tax cost of debt at a 25% tax rate gives 3.75% after tax.
WACC is 0.70 times 9.6% plus 0.30 times 3.75%, which is 7.8%. Move beta to 1.4 and it becomes 8.6%, a large shift in value on a long dated cash flow stream.