Term · Valuation
WACC / Cost of Capital
In briefThe WACC bundles the return requirements of equity and debt providers into a weighted average and often serves as the discount rate for cash flows to all capital providers. For small caps, a WACC that is too low can substantially overstate the calculated enterprise value.
Definition
The WACC is the weighted average return requirement of equity and debt providers. It often serves as the discount rate for cash flows to all capital providers.
How it is calculated
Formula. WACC = E/(D+E) x cost of equity + D/(D+E) x cost of debt x (1 - tax rate).
Why it matters for small caps
Small caps often have higher business, liquidity and financing risks. A WACC that is too low can therefore significantly overstate the calculated enterprise value.
Common misreadings
- A blanket small-cap premium does not replace a consistent derivation. Capital structure, country, currency and business risks must not be double-counted.
In the process
Frequently asked
What is the WACC?
It is the blended rate of cost of equity and cost of debt, weighted by the capital structure. It expresses the minimum return that all capital providers expect.
How is the WACC calculated?
You weight the cost of equity and cost of debt by their respective financing share and account for the tax deductibility of debt interest. This produces the combined cost of capital.
What mistake happens in deriving the WACC?
A blanket small-cap premium does not replace a consistent derivation. Capital structure as well as country, currency and operating risks should not be counted more than once.
Related terms
Sources
Primary
NYU Stern – Aswath Damodaran, Valuation Resources
https://pages.stern.nyu.edu/\~adamodar/
https://pages.stern.nyu.edu/\~adamodar/
Education only, not investment advice. Ranges and thresholds are didactic orientation values, not an official standard.