Understanding the Weighted Average Cost of Capital (WACC)

Every financial decision counts when you’re running a business. And knowing how much your funding really costs can help you make smarter choices, whether you’re just starting out or planning your next big expansion. Understanding how much your business spends on funding can guide your decisions and this is where the weighted average cost of capital can help.

The weighted average cost of capital (WACC) is the average cost of all the money your business uses to grow. This includes money from loans, investors and potentially even your own pocket. Businesses large and small can use WACC to help compare financing options, evaluate projects and ultimately save money.

In this article, we’ll help you calculate your WACC, understand why it matters and advise you how to use it to your advantage.

What is the weighted average cost of capital (WACC)?

WACC is the average cost your business pays to use all the money that funds its growth. This includes the cost of debt (like loans and credit cards) and the cost of equity (like your own investment or money from shareholders). It blends these costs together to calculate a single percentage that represents your overall cost of capital

You can break down WACC into three key components:

• Cost of equity: This is the return you or your investors expect for putting money into your business. If you’ve funded your business yourself, think of it as the return you’d want if you invested that money somewhere else. Learn about the cost of equity formula.

• Cost of debt: This is the interest you pay on loans, adjusted for tax savings (since interest payments are usually tax-deductible). Learn about the cost of debt formula.

• Weights: These are the proportions of debt and equity in your total funding. For example, if you’ve funded your business with 60% loans and 40% personal savings, those are your weights.

For example, let’s imagine you have:

• £10,000 in loans at 7.5% interest

• £5,000 of your own money invested in the business

• Your cost of equity is 12%

• Your after-tax cost of debt is 6%

In this case, your WACC would be 8.04%. We’ll show you how to calculate this in the next section.

You can use WACC to help weigh up your different funding options, like a business loan versus a business credit card, or to decide whether a new project is worth the investment.

How do I calculate WACC for my business?

The WACC formula combines the cost and proportion of each type of funding to give you your overall cost of capital:

Let’s break the formula down:

• E = Value of equity (your investment + any investor money)

• V = Total value of your funding (debt + equity)

• Re = Cost of equity (the return expected by you or your investors)

• D = Value of debt (your loans)

• Rd = Cost of debt (your loan’s interest rate, after tax)

• T = Your corporation tax rate

You can calculate WACC in four simple steps. Here’s how to do it…

1. Estimate your cost of equity: If you’re self-funded, this is the return you’d expect from a low-risk investment, like 10-15%. If you have investors, it’s the return they expect.

2. Calculate your after-tax cost of debt: Take your loan’s interest rate and subtract the tax savings. For example, if your loan is 7.5% and your corporation tax rate is 20%, your after-tax cost is 6% (7.5% * (1 - 0.20)). If you have multiple debts, calculate a weighted average of their after-tax costs.

3. Determine your weights: Divide your total debt by your total funding to get the debt weight. Do the same for equity. For example, if you have £10,000 in loans and £5,000 of your own money, your weights are 67% debt and 33% equity.

4. Plug the numbers into the formula: Using the example above, with a 12% cost of equity and 6% cost of debt, your WACC would be: WACC = (0.33 * 12%) + (0.67 * 6%) = 8.04%.

How does WACC help my business?

Understanding your weighted average cost of capital helps you make better financial decisions. If a project or investment is expected to return more than your WACC, it’s usually a good idea. If it’s less, you may want to rethink the approach.

How WACC applies to your business stage

• 0-6 months: Start ups typically have a higher WACC because investors and lenders want higher returns to compensate for the risk of backing a new business. At this stage, WACC can help you determine if an idea’s worth developing. For example, if your WACC is 15% and your projected return is only 10%, the idea may not be viable unless you can reduce costs or increase potential returns. You could also use WACC to compare funding options like a business loan against higher-cost options like credit cards. A lower WACC shows less financial strain and more room for growth.

• 6-12 months: As your business gains traction, your WACC may start to drop as you access cheaper funding options like a merchant cash advance or invoice finance. At this stage, WACC can help you evaluate which option is the most cost-effective way to expand your team or inventory. For example, if your WACC is 12% and a merchant cash advance costs 15%, you might opt for a loan at 10% instead. WACC can also help you assess whether growth projects, like hiring or marketing campaigns, will deliver returns that justify their cost.

• 12+ months: Established businesses often have a lower WACC due to better creditworthiness and access to cheaper debt and equity. Here, WACC can be used as a discount rate in Discounted Cash Flow (DCF) valuations to determine your business’s value or to evaluate bigger investments (eg acquiring assets or entering new markets). For example, if you’re deciding between leasing equipment (with a cost of 8%) or buying it with a loan (6% after tax), WACC can help you choose the option that aligns with your long-term financial strategy.

If you feel external finance is overwhelming or too risky, WACC can cut through the confusion by giving you a clear way to understand the costs.

And remember, WACC isn’t just used for big decisions. Even everyday choices, like whether to use an overdraft or a credit card for short-term cash flow, can be clearer when you understand your cost of capital.

Examples of using WACC

Scenario 1: Cafe owner (0-6 months)

You’re opening a cafe and need £5,000 to buy a new coffee machine and refurbish the space. You’ve already invested £3,000 of your own savings and now you’re deciding how to fund the remaining £5,000 needed for the additional refurbishments.

You consider two options:

• A business credit card with an 18% interest rate

• Revenue-based financing, where you repay 10% of your daily card sales until you’ve paid back £6,000 (equivalent to an annual cost of around 12%)

Since you’re self-funded, your cost of equity is the return you’d expect if you invested your £3,000 elsewhere – let’s say 15%. Your total funding is £8,000 (£3,000 equity + £5,000 debt), so your equity weight is 37.5% and your debt weight is 62.5%.

• If you use the credit card, your WACC is: (37.5% * 15%) + (62.5% * 18%) = 5.63% + 11.25% = 16.88%

• If you use revenue-based financing, your WACC is: (37.5% * 15%) + (62.5% * 12%) = 5.63% + 7.5% = 13.13%

Revenue-based financing gives you a lower WACC. It also aligns repayments with your cash flow, making it less risky for a new business. You choose revenue-based financing to keep costs down and avoid fixed monthly payments.

Scenario 2: Online store (6-12 months)

Your online store is growing and you need £20,000 to expand your inventory for the busy season. You’ve reinvested £10,000 of profits into the business.

You consider two options:

• A term loan at 8% interest (6.4% after tax)

• A business overdraft at 12% interest (9.6% after tax)

Your cost of equity is 12% (the return you expect on your reinvested profits). Your total funding is £30,000 (£10,000 equity + £20,000 debt), so your equity weight is 33% and your debt weight is 67%.

• If you take the term loan, your WACC is: (33% * 12%) + (67% * 6.4%) = 4% + 4.29% = 8.29%

• If you use the overdraft, your WACC is: (33% * 12%) + (67% * 9.6%) = 4% + 6.43% = 10.43%

The term loan has a lower WACC. It also offers fixed repayments, which makes budgeting easier. You choose the term loan to keep your financing costs predictable.

Scenario 3: Manufacturing firm (over 12 months)

You’re deciding whether to lease or buy a £50,000 machine for your factory. You have £30,000 in retained earnings and need an extra £50,000.

You consider two options:

• An equipment loan at 7% interest (5.6% after tax)

• An equipment lease with an implicit cost of 9% (no tax deduction)

Your cost of equity is 10% (the return you expect on your retained earnings). Your total funding is £80,000 (£30,000 equity + £50,000 debt), so your equity weight is 37.5% and your debt weight is 62.5%.

• If you take the equipment loan, your WACC is: (37.5% * 10%) + (62.5% * 5.6%) = 3.75% + 3.5% = 7.25%

• If you lease the equipment, your WACC is: (37.5% * 10%) + (62.5% * 9%) = 3.75% + 5.63% = 9.38%

The equipment loan gives you a lower WACC (7.25% vs 9.38%). But leasing offers flexibility, like the option to upgrade the machine in a few years, so you might still choose it if that flexibility is worth the extra cost. You decide to buy with the equipment loan, as the lower WACC aligns with your long-term growth plans.

How can I improve (reduce) my WACC?

A lower WACC means cheaper funding and more profit for your business. Here’s how to reduce yours, no matter what stage you’re at.

If your business is 0-6 months old:

• Build your business credit score with small business loans or credit builder tools like Tide’s Credit Score Insights

• Avoid using high-interest debt, such as credit cards, for long-term needs

If your business is 6-12 months old:

• Try negotiating better loan terms by improving your cash flow and revenue stability

• Consider revenue-based financing if traditional loans are too expensive or hard to qualify for

If your business is over 12 months old:

• Balance equity and debt to minimise costs (eg by using retained earnings instead of taking on high-interest loans)

• Explore alternative lenders, like P2P platforms, which often offer competitive rates

You could also reduce your WACC by diversifying your funding sources. Non-bank lenders, asset finance and even business grants can all help bring your average cost down.

Wrapping up

WACC is the average cost of all the money your business uses to grow. It helps you review your funding options and evaluate projects so you can focus on what really moves the needle.

Here’s a reminder of what to focus on when using WACC for your business:

• Start with your funding goals: Think about what you need the money for (is it stability, growth, or seizing a new opportunity?) and make sure your funding choices align with your business stage and cash flow.

• Compare your options carefully: Look for funding that fits your WACC and feels manageable. Whether it’s a merchant cash advance or a term loan, trust the numbers but also trust your instincts if something doesn’t feel right.

• Get a clear picture of your costs: WACC mainly focuses on interest rates. But consider the flexibility, repayment terms and tax implications of each option.

• Plan for the long term: Choose funding that supports your growth without overstretching your finances. Leave room for unexpected costs and changes in interest rates.

• Ask the right questions: If you’re comparing a loan, overdraft, or investor funding, consider the details carefully. What’s the real cost after tax? How will repayments affect your cash flow? Are there hidden fees or penalties?

• Use the tools available to you: You don’t have to figure it all out alone. Using resources like this one and seeking expert advice can help you navigate your choices with confidence.

FAQs

What is a good WACC for a small business?

There’s no single ‘good’ WACC for a small business, but a good WACC is one that’s lower than the return on your projects. So if your business consistently earns returns on its projects that exceed your WACC, you’re likely creating value for your investors and the business itself. A WACC that’s too high relative to your project returns can erode your profitability and make it harder to justify new investments.

Can I calculate WACC if I don’t have investors?

Yes. Your cost of equity is the return you’d expect if you invested your money elsewhere, like 10-15%.

How does WACC differ for start ups vs established businesses?

Start ups often have higher WACC because they rely on riskier funding, like credit cards or personal loans. Established businesses can access cheaper debt and equity.

Why is the after-tax cost of debt used in WACC?

Interest payments are tax-deductible, so the after-tax cost reflects your real expense. For example, a 7.5% loan costs ~6% after 20% corporation tax.

How often should I recalculate my WACC?

Recalculate when your funding changes (eg when taking out a new loan) or when interest rates change.

Does WACC apply to sole traders?

Yes. Even if you’re self-funded, WACC can help you compare options like loans vs personal savings.

What’s the difference between WACC and interest rate?

WACC includes all funding costs (loans and equity) while an interest rate only applies to debt.

Can WACC help me choose between a loan and an overdraft?

Yes. You can compare their after-tax costs to see which fits your WACC better.

Is a lower WACC always better?

Generally, yes. But you may not want to sacrifice growth for small savings. Aim to balance cost with opportunity.

How does WACC relate to my business credit score?

A better credit score gives you access to cheaper debt, which lowers your WACC.

What if my business only uses debt?

Your WACC is just your after-tax cost of debt. But diversifying with equity can sometimes lower your overall cost.

Photo by Alesia Kazantceva on Unsplash