WACC — building a discount rate you can defend

The weighted average cost of capital (WACC) is the discount rate used to value free cash flow to the firm. It blends the cost of equity and the after-tax cost of debt at the company's target capital-structure weights. The economic intuition: a company that funds itself with 40% debt and 60% equity has investors with two different return requirements, and the firm's overall cost of capital is a weighted average of those two requirements. Get the WACC wrong and the entire DCF answer is wrong — a 100 basis-point error in WACC typically moves enterprise value by 10-30%, because the discount rate compounds in the denominator of every projected cash flow.

The formula in full

                E                          D
  WACC  =  ─────────  ×  Ke   +    ─────────  ×  Kd  ×  ( 1  −  t )
              D + E                       D + E

Variable glossary — every input explained

• WACC — the weighted average cost of capital, expressed as a decimal. The single discount rate applied to free cash flow to the firm. Typical ranges: 6-9% for developed-market investment-grade companies, 10-14% for Kenyan listed corporates, 14-20% for Kenyan unlisted mid-caps. The 'right' WACC is the one that compensates all of the firm's capital providers for the risk they bear.
• E — the market value of equity, in currency units. For a listed company, equity market cap = current share price × diluted shares outstanding. For a private company, an estimated market value derived from comparable trading multiples or a prior funding round. Use market value rather than book equity — the model is asking what fresh capital would cost today.
• D — the market value of interest-bearing debt, in currency units. Use market value if the debt is publicly traded and quoted; otherwise book value of debt is an acceptable approximation when rates have not moved much since issuance. Exclude operating liabilities like accounts payable and accrued expenses — these are not capital providers in the WACC sense.
• D + E — total firm capital, the denominator that normalises the two weights to sum to 1. Sometimes called the 'invested capital' or 'capitalisation' of the firm. Preferred stock, if present, gets its own weight and own cost — small companies typically have none.
• Ke — the cost of equity, expressed as a decimal. The annual percentage return equity investors require for bearing equity risk in this company. Usually computed via CAPM in the next module: Rf + β × ERP. For Kenyan listed equities Ke typically falls 14-22%; for developed-market large caps 8-11%.
• Kd — the cost of debt before tax, expressed as a decimal. The pre-tax interest rate the company would have to pay to borrow new debt today. The correct number is the yield to maturity on the company's existing public bonds, or a credit-spread-implied yield if the company has only bank debt. Coupons set at issuance are not the answer — yields update with the market.
• t — the marginal corporate tax rate, expressed as a decimal. The rate that applies to the next dollar of taxable income, used because interest expense reduces taxable income by exactly that next-dollar amount. Kenyan resident corporates: 30%. US federal corporate: 21% (plus state, often a combined 25-28%). Effective tax rates from prior filings are usually lower than marginal and are not the right input.
• ( 1 − t ) — the tax-shield adjustment that converts Kd from pre-tax to after-tax. Interest is tax-deductible (in most jurisdictions, including Kenya), so each shilling of interest paid reduces tax by t shillings. The effective after-tax cost of borrowing is therefore Kd × (1 − t). For a Kenyan corporate with Kd = 13% and t = 30%, after-tax Kd = 9.1%.

A worked WACC computation, end to end

Hypothetical Kenyan-listed corporate:
  Share price:               KES 25.00
  Shares outstanding:        400m
  Market equity (E):         400m × 25 = KES 10,000m
  Net debt at market (D):    KES 4,000m
  Total capital (D + E):     KES 14,000m

  Equity weight  E / (D+E):  10,000 / 14,000  =  71.4%
  Debt weight    D / (D+E):   4,000 / 14,000  =  28.6%

  Cost of equity (Ke):       17.0%  (computed via CAPM, next module)
  Pre-tax cost of debt (Kd): 13.5%  (yield to maturity on outstanding bonds)
  Marginal tax rate (t):     30%    (Kenyan resident corporate rate)

  After-tax Kd  =  13.5%  ×  (1 − 0.30)  =  9.45%

  WACC  =  0.714 × 0.170  +  0.286 × 0.0945
       =  0.1214  +  0.02702
       =  0.1484  =  14.84%

Interpretation: every project this company runs must clear a 14.84%
IRR hurdle to create value. Discount every projected free cash flow
at 14.84%. A 100 bp error in WACC moves enterprise value by
approximately 12-15% for a typical 5-year explicit forecast plus
Gordon-growth terminal value.

Use market values, not book values

The WACC formula's weights must reflect what the firm's capital is worth today, not what the firm originally paid for it. Equity weight uses market capitalisation, not book equity — book equity is a backward-looking accounting concept and could be a tiny fraction (or a large multiple) of market value. Debt weight ideally uses the market value of outstanding debt, which equals book if the debt has not moved much from issuance, or differs materially if rates have moved. The point of WACC is the cost of raising new capital today, not the historical cost recorded on the balance sheet.

Cost of debt — yield to maturity, not coupon

Use the yield to maturity on the company's outstanding debt, not the coupon. If the company's bonds trade at a yield of 13.5% but the coupon is 10%, the cost of new debt is 13.5% — that is what the company would pay today on fresh borrowing, which is what WACC tries to capture. Coupon at issuance is a historical artefact. The after-tax adjustment (1 − t) reflects the tax-deductibility of interest. For a Kenyan corporate at 30% marginal rate, 13.5% × (1 − 0.30) = 9.45% after-tax.

Cost of equity — set up for the next module

Cost of equity is harder than cost of debt because no observable market price quotes it directly. The standard tool is CAPM: Ke = Rf + β × ERP. Each input — risk-free rate, beta, equity risk premium — is itself a judgement call, and small differences across analysts compound into materially different Ke estimates. The next module unpacks each input with full variable glossaries and worked Kenyan examples.

Target weights, not current weights

WACC is a forward-looking concept. If a company is over-leveraged today and plans to deleverage to a target capital structure within the projection window, use the target weights in WACC, not today's. If a peer set operates at 25% debt-to-enterprise-value but your target firm is modelled with 60%, the valuation is implicitly being applied to a different business than the comparables suggest. Either re-lever the peers' betas to your assumed structure or change the structure assumption — internal consistency matters.