WACC, explained like I’m not a finance person ('cause I'm not)
If money had a price tag, WACC would be it. In plain terms, the weighted average cost of capital (WACC) is simple: to fund a business you use two kinds of money: borrowed money (loans from banks, friends, or family) and shareholders’ capital. The shareholders’ contribution is your equity, which is cash put into the company in exchange for shares. Loans typically have an interest rate you can read on a contract. Shareholders will not ask you for monthly payments, but they still expect a return for taking risk. Blend those two prices of money according to how much of each you use, and you get one average price. That average is your WACC.
Picture a neighbourhood café deciding whether to open a second location. The bank offers a loan at 6% (cost of debt). Friends who own shares in the café say they would be happy if their investment earned around 12% a year over time (cost of equity). Half the funding will be a loan, and half will be shareholders’ capital. If you average those costs, and remember that loan interest is usually tax deductible so the effective cost of debt is a bit lower, you land around 8.25%. That 8.25% is the café’s hurdle. If the new location’s expected return on the capital invested, measured in plain terms by its free cash flow to the firm (FCFF), the cash the whole business generates before interest, after tax, and after the reinvestment it needs, clears 8.25% by a sensible margin, it is creating value. If it struggles to reach 8.25%, the safer move might be to repay debt, spruce up the current shop, or simply keep the cash.
Here is another example of back of the napkin math that shows the effect of weighting: say it borrows €30 at 6% and uses €70 of shareholders’ capital expecting 12%. If the tax rate is 25%, the after tax cost of debt is 6% × (1 − 0.25) = 4.5%. Weight those by their shares, 30% debt and 70% equity, and you get WACC = 0.30 × 4.5% + 0.70 × 12% = 1.35% + 8.40% = 9.75%. You do not need to memorise the formula to grasp the logic. We are simply asking: “On average, what does our money cost us?”
Once you know that average cost of money, two things become clearer. First, it helps you judge investments: if a project can earn more than 9.75% when your WACC is 9.75%, it’s adding value; if it only earns 7%, it probably isn’t worth the risk (this is a tad too simplified but it gives the gist). Second, it helps you link future expectations to today’s choices: when you value a business or project, you bring back the cash you expect in the future and discount it at your WACC. That way you check whether the return clears the minimum hurdle your money demands.
There are a few traps to avoid. Comparing a project’s return before tax to a WACC that uses after tax debt is an apples to oranges mistake. Copy pasting a number from a friend’s company is another, because WACC is local and it moves with interest rates, risk, and leverage. And not every project inside the same company deserves the same hurdle. A new pastry line for the café might reasonably be judged at the company’s average, while a plan to open a location in a volatile tourist town might call for a higher bar.
Money has a price. Shareholders’ capital is usually the expensive kind because it carries the risk. Debt is cheaper, but only up to what your business can safely handle. Blend the two by how much you use, and back ideas that clear that blended cost by a sensible margin. That is how you protect what you have built and let returns compound.