How to Calculate WACC Step by Step (With a Worked Example for IB Interviews)

If you're prepping for investment banking interviews, you will get asked about WACC. It might be "walk me through how you calculate WACC," or it might be a sneaky follow-up like "what happens to WACC if the company takes on more debt?"

The good news: WACC is just a weighted average of what it costs a company to raise money. Once you see it built from scratch with real numbers, it clicks. That's exactly what we'll do here, one step at a time.

What WACC Actually Is (In Plain English)

A company funds itself with two main sources of capital: equity (shareholders) and debt (lenders). Each group expects a return for handing over its money.

WACC, the Weighted Average Cost of Capital, blends those two expected returns based on how much of each the company uses. In a DCF, it's the discount rate you apply to unlevered free cash flows, because those cash flows belong to both debt and equity holders.

Here's the formula:

WACC = (E / V) × Re + (D / V) × Rd × (1 − t)

Where:

• E = market value of equity
• D = market value of debt
• V = E + D (total capital)
• Re = cost of equity
• Rd = pre-tax cost of debt
• t = tax rate

If the company has preferred stock, you add a third term: (P / V) × Rp. Most interview questions skip it, but it's worth mentioning to show you know.

Our Example Company

Let's build WACC for a made-up company, NorthPeak Industrial. Here's what we know:

• Share price: $40
• Diluted shares outstanding: 50 million
• Debt: $500 million (trading close to par)
• Yield to maturity on its bonds: 6.0%
• Tax rate: 25%
• Risk-free rate (10-year Treasury yield): 4.0%
• Equity risk premium: 5.5%
• A comparable public company has a levered beta of 1.3 and a debt-to-equity ratio of 0.4

Now let's go step by step.

Step 1: Find the Market Value of Equity

Use market value, not book value. Book equity reflects historical accounting, while market value reflects what investors actually think the company is worth today.

Equity value = Share price × Diluted shares

$40 × 50 million = $2,000 million

Use diluted shares (including in-the-money options and other dilutive securities), because those could become real shares.

Step 2: Find the Market Value of Debt

Ideally, you'd use the market value of the company's debt. In practice, bankers often use book value as a proxy when the debt trades near par, since the two are usually close.

NorthPeak's debt trades near par, so:

Debt value = $500 million

Step 3: Calculate the Capital Weights

Total capital: $2,000M + $500M = $2,500 million

• Equity weight (E/V): $2,000 / $2,500 = 80%
• Debt weight (D/V): $500 / $2,500 = 20%

Interview tip: in a real model, you'd often use a target or industry-average capital structure instead of the company's current one, especially if the current mix is unusual or expected to change. Bringing this up unprompted sounds sharp.

Step 4: Calculate the Cost of Equity (CAPM)

This is the step with the most moving parts. The standard tool is the Capital Asset Pricing Model:

Re = Risk-free rate + Beta × Equity risk premium

The risk-free rate and equity risk premium are given. The tricky part is beta.

Why You Unlever and Relever Beta

Beta measures how risky a stock is relative to the market. But beta mixes two kinds of risk:

• Business risk (how volatile the operations are)
• Financial risk (how much leverage the company carries)

Comparable companies have different amounts of debt, so you can't just copy their betas. You first unlever their betas to strip out leverage, then relever at your company's capital structure.

Unlevering the Comparable's Beta

Unlevered beta = Levered beta / [1 + (1 − t) × (D/E)]

For our comparable:

• 1 + (0.75 × 0.4) = 1 + 0.30 = 1.30
• Unlevered beta = 1.3 / 1.30 = 1.00

In real life you'd do this for a whole set of comps and take the median or average. One comp keeps the math clean here.

Relevering at NorthPeak's Capital Structure

NorthPeak's D/E = $500 / $2,000 = 0.25

Levered beta = Unlevered beta × [1 + (1 − t) × (D/E)]

• 1 + (0.75 × 0.25) = 1 + 0.1875 = 1.1875
• Levered beta = 1.00 × 1.1875 = 1.1875

NorthPeak carries less leverage than the comp, so its relevered beta (about 1.19) comes out lower than the comp's 1.3. That makes sense: less debt, less financial risk.

Plugging Into CAPM

• Re = 4.0% + 1.1875 × 5.5%
• Re = 4.0% + 6.53%
• Re ≈ 10.53%

Step 5: Calculate the After-Tax Cost of Debt

The pre-tax cost of debt is what the company would pay to borrow today. The best measure is the yield to maturity on its existing bonds, not the coupon rate. The coupon reflects market conditions when the bond was issued, which could be years ago.

If the company's debt doesn't trade, you can estimate Rd from its credit rating and the yields on similarly rated debt.

Next, adjust for taxes. Interest is generally tax-deductible, so the government effectively shares part of the cost.

After-tax Rd = Rd × (1 − t)

6.0% × (1 − 0.25) = 4.5%

Step 6: Put It All Together

Now just plug everything into the formula:

So NorthPeak's WACC is about 9.3%. That's the rate you'd use to discount its unlevered free cash flows in a DCF.

Why a Small Change in WACC Matters So Much

WACC sits in the denominator of every discount factor, so small tweaks swing valuation a lot.

Quick illustration: imagine a company with next year's free cash flow of $102 million, growing 2% forever.

• At a 9% discount rate: $102 / (9% − 2%) = about $1,457 million
• At a 10% discount rate: $102 / (10% − 2%) = $1,275 million

A single percentage point knocked roughly 12.5% off the value. That's why bankers always show WACC sensitivity tables.

WACC Questions Interviewers Love to Ask

"Why is the cost of debt taxed but not the cost of equity?"

Interest payments are tax-deductible, which lowers the true cost of borrowing. Dividends and equity returns are not deductible, so there's no tax shield on the equity side.

"Which is usually higher, cost of equity or cost of debt?"

Cost of equity. Equity holders get paid last in a bankruptcy and have no guaranteed payments, so they demand a higher return than lenders.

"If debt is cheaper, why not fund the company with 100% debt?"

Great trap question. As leverage rises:

• Cost of equity rises, because shareholders bear more financial risk (that's the relevered beta going up)
• Cost of debt rises, because lenders worry about default
• Bankruptcy risk climbs

WACC tends to fall as you add moderate debt, then starts rising once the risks outweigh the tax benefit.

"What happens to WACC if the tax rate goes up?"

All else equal, a higher tax rate lowers the after-tax cost of debt, so WACC goes down. (A truly complete answer notes that the tax rate also shows up in the beta formulas, but the headline answer is that WACC decreases.)

"Why use market values instead of book values?"

Because WACC should reflect what it costs to raise capital today, and market values show what investors currently think the equity and debt are worth.

Common Mistakes to Avoid

• Using the coupon rate instead of the current yield for cost of debt
• Using book value of equity for the weights
• Copying a comp's levered beta without unlevering and relevering
• Forgetting the (1 − t) on the cost of debt
• Discounting levered free cash flow at WACC. WACC goes with unlevered FCF; levered FCF gets discounted at the cost of equity

The 30-Second Interview Answer

If someone asks you to walk through WACC, here's a clean version:

"WACC is the blended cost of a company's capital. First, I'd find the market values of equity and debt to get the weights. For cost of equity, I'd use CAPM: risk-free rate plus beta times the equity risk premium, where beta comes from unlevering comparable companies' betas and relevering them at the target capital structure. For cost of debt, I'd use the yield on the company's debt and multiply by one minus the tax rate. Then I weight each cost by its share of total capital and add them up."

Practice saying that out loud a few times, then rebuild the NorthPeak example on a blank sheet of paper without looking. If you can do both, you're ready for whatever WACC question comes your way.