WACC vs cost of equity
Two rates, two questions. Cost of equity is what the owners expect to earn. WACC is what the company must earn, on average, to satisfy both owners and lenders.
What the two rates mean
Most companies are funded by two groups. Owners put in equity. Lenders put in debt. Each group wants a return for the risk it takes.
Cost of equity
The return owners expect on their shares. They are paid last, so they usually ask for more than lenders. In formulas this is often written as ke.
WACC
The weighted average cost of capital: one blended rate for the whole pool of money. It mixes the owners’ return with the cost of debt, after the tax saving on interest. If there is no debt, WACC equals the cost of equity.
Both rates answer the same practical question: what return is high enough to justify tying up money? The difference is whose money you are counting. See the WACC guide for the formulas behind each piece.
The rule
Match the rate to the cash you are valuing.
- Use WACC for cash the business generates before paying lenders — the usual starting point when you value a company or a project as a whole.
- Use the cost of equity for cash that belongs only to owners, such as dividends or profit left after interest.
Using the wrong pair is the common mistake: a company-level cash forecast with the owners’ rate, or an owners-only cash forecast with WACC. The first makes the business look less valuable than it is. The second makes the equity look more valuable than it is.
Side-by-side
| Topic | Cost of equity | WACC |
|---|---|---|
| Who must be paid | Only the owners (shareholders) | Owners and lenders, in one blended rate |
| What it measures | The return owners expect for the risk they take | The average cost of all the money used by the company |
| Which cash flows it fits | Cash that belongs only to owners: dividends or profit after interest | Cash generated by the business before paying lenders |
| Typical use | Valuing an equity stake, or a project funded only with equity | Valuing the whole company, or a project funded with equity and debt |
| If the company borrows more | Owners usually demand a higher return, because risk rises | The average can fall at first, then rise if debt becomes expensive |
When to use each
Use cost of equity when
- You are valuing the shares, not the whole company
- You are looking at dividends or profit after interest
- The investment is funded only with equity
- You want to know whether the return on equity covers what owners expect
Use WACC when
- You are valuing the company as a whole
- You are deciding whether a project creates value
- The project will be funded with a mix of equity and debt
- You want to know whether the business earns more than the cost of all its capital
The WACC calculator reports both rates, so you can choose the one that matches the cash you have in front of you.
A worked example
A company is worth 100. Owners provide 70, lenders provide 30. Owners expect 12%. Lenders charge 6% before tax. The tax rate is 25%, so the after-tax cost of debt is 4.5% — interest reduces taxable profit, which is why WACC uses the lower figure.
In words: 70% of the capital costs 12%, and 30% costs 4.5% after tax. The blended required return is 9.75%.
If the business is expected to produce 100 next year, before paying lenders, that cash is worth about 91 today at 9.75%. Using 12% on the same cash would understate the company, because part of the funding is cheaper debt. Using 9.75% on cash that already belongs only to owners would overstate the shares.
Common mistakes
- Using accounting weights. WACC should reflect what equity and debt are worth in the market today, not the mix shown on the balance sheet.
- Ignoring tax on interest. In most countries interest is deductible, so the relevant cost of debt in WACC is after tax.
- Keeping the owners’ rate fixed when debt rises. More borrowing makes the shares riskier, so the cost of equity should rise. The cost of equity section shows how leverage enters beta.
- Using a rate from another country. The risk-free rate, market premium, and tax should match the currency and country of the cash flows you are valuing.
WACC vs cost of equity FAQ
Is WACC always lower than the cost of equity?
Usually yes, because lenders typically accept a lower return than owners, and interest often reduces tax. If the company has no debt, the two rates are the same. The gap shrinks if debt is very expensive or if interest is not tax-deductible.
Can I value a whole company using the cost of equity?
Not if you are looking at cash the business generates before paying lenders. That cash has to satisfy both owners and lenders, so the matching rate is WACC. Use cost of equity only for cash that belongs to owners after interest.
Can I judge a new project with the cost of equity?
Yes, if the project is funded only with equity and has a similar risk to the company’s shares. Most company projects are funded with a mix of equity and debt, so WACC is the usual benchmark. Adjust it if the project is clearly riskier or safer than the existing business.
Why can more debt lower WACC?
Debt is usually cheaper than equity, especially after the tax saving on interest. Replacing some equity with debt can therefore pull the average down. The benefit is not unlimited: more debt makes owners and lenders demand higher returns.