The rate you were told to take as given

The last post discounted cash flows at 13.91% and asked you to accept the number on faith. It also showed that this single input swings the answer more than almost anything else in a valuation. Time to earn it.

The rate you discount at should reflect what the money you’re valuing costs. A company is funded from two pockets — shareholders and lenders — and each pocket demands a different return. WACC — the weighted average cost of capital — blends the two in proportion to how much of each the company actually uses.

Think of it as the hurdle rate. If a business can’t earn more than its WACC on the money it deploys, it’s destroying value no matter how healthy the profit line looks. (This is also the honest answer to why ROCE matters — with one adjustment. ROCE is a pre-tax return and WACC is an after-tax cost, so compare WACC with ROCE × (1 − tax rate), roughly what analysts call ROIC, return on invested capital. Above WACC is value creation; below it isn’t.)

The formula

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

where  E  = market value of equity
       D  = market value of debt
       Ke = cost of equity
       Kd = cost of debt (pre-tax)
       t  = corporate tax rate

Two things in there aren’t obvious.

Why the (1 − t) on debt only. Interest is a tax-deductible expense in India, so borrowing ₹100 at 10% doesn’t really cost the company ₹10 — it costs ₹10 minus the tax it no longer pays on that ₹10. Dividends get no such treatment. That deductibility is a genuine, structural advantage of debt over equity, and the formula has to reflect it.

Why equity is more expensive than debt. It reliably surprises people that Ke comes out higher than Kd. Lenders get paid first, get contractual interest, and usually hold security. Shareholders get whatever’s left over, after everyone else, with no promises attached. For accepting that, they demand more. Equity is the expensive money.

Step 1: the cost of equity

There’s no invoice for what shareholders expect — nobody sends the company a bill. It has to be estimated, and the standard tool is the capital asset pricing model (CAPM):

Ke = Risk-Free Rate + Beta × Equity Risk Premium
Input What it is Where to get it
Risk-free rate Return on a genuinely safe asset 10-year Government of India bond yield
Equity risk premium Extra return investors demand for holding stocks over bonds Estimated, not observed. Aswath Damodaran’s widely used country risk table put India’s total ERP at about 7.1% in its January 2026 update; other estimates sit a point or so either side
Beta How much this stock moves relative to the overall market Regression against an index, or a sector average

Beta is the piece worth pausing on. A beta of 1.0 means the stock tends to move with the market. Above 1.0 means it swings harder in both directions; below 1.0 means it’s steadier. CAPM’s core claim is that investors should be compensated for the risk they can’t diversify away — the market-wide kind — and beta is its measure of that.

It’s also the model’s weakest limb. Beta is estimated from past price movements, and a company’s future volatility need not resemble its past. Treat it as a defensible convention rather than a measurement.

Step 2: the cost of debt

This one is easier, because there is an invoice. A company’s interest expense and its borrowings are both sitting in the accounts:

Kd (pre-tax) = Interest Expense / Average Total Debt

For a company with recently issued debt, the yield on that debt is better still. But the accounts version is usually close enough and always available.

Worked example: Desi Bites Foods Ltd

Building the rate used throughout this series’ discounted cash flow (DCF) model. First, the cost of equity:

Input Value Source
Risk-free rate 6.5% Illustrative round figure. The 10-year G-Sec (Government Security) yield spent 2025 in the low-to-mid 6s; for a real valuation, take the yield on your valuation date from CCIL or FBIL
Equity risk premium 7.0% Illustrative India ERP, in line with the estimates above
Beta 1.1 Illustrative, small-cap packaged foods
Cost of equity 14.2% 6.5 + 1.1 × 7.0

Then the cost of debt, which for once comes straight out of the case study rather than being assumed:

Input Value Source
FY25 interest expense ₹47 lakh Income statement
Average term loan ₹430 lakh (FY24 ₹460 + FY25 ₹400) / 2
Cost of debt, pre-tax 10.93% 47 / 430
Tax rate 25% Rounded from the Section 115BAA domestic rate: 22% + 10% surcharge + 4% cess = 25.17%
Cost of debt, after tax 8.2% 10.93 × (1 − 0.25)

Now the weights. These use market values, not book values — the whole point is what capital costs today, and Desi Bites’ equity is worth its ₹8,000 lakh market capitalisation at the IPO price, not the ₹2,278 lakh of book equity:

  ₹ lakh Weight
Equity (market cap) 8,000 95.2%
Debt 400 4.8%
Total capital 8,400 100%

And the blend:

WACC = 0.952 × 14.20%  +  0.048 × 8.20%
     = 13.52%          +  0.39%
     = 13.91%

The result sits almost on top of the cost of equity, and that’s not a coincidence. Desi Bites is 95% equity-funded at market values, so the cheap debt barely moves the average. Worth internalising: for most equity-heavy companies, WACC is the cost of equity with a rounding error attached, and agonising over the cost of debt is wasted effort.

Worked example: Britannia’s cost of debt

The one piece of a real company’s WACC that can be read directly off the filings, rather than estimated. From the audited consolidated FY25 results. For illustration only.

  ₹ crore
FY25 finance costs 138.8
Total borrowings, FY24 2,041.21
Total borrowings, FY25 1,224.77
Average borrowings 1,632.99
Cost of debt, pre-tax 8.5%

Its effective tax rate is also observable — ₹748.71 crore of tax on ₹2,926.57 crore of pre-tax profit, or 25.6%. So Britannia’s after-tax cost of debt is roughly 8.5 × (1 − 25.6%), a little over 6%. One caveat: reported finance costs also include interest on lease liabilities and other items that aren’t in “borrowings”, so this ratio, if anything, overstates the true borrowing rate.

Note how much cheaper that is than Desi Bites’ 10.93%. Large, established, low-leverage borrowers get better terms than small ones — which is itself a real competitive advantage, and one that never shows up in a margin.

The rest of Britannia’s WACC — its beta, its equity risk premium — would be estimated, not observed, and this blog isn’t going to publish a discount rate for a real listed company. That’s a short step from publishing a valuation for it, and this is an educational blog, not a research service.

The circularity nobody mentions

Look again at the weights in the Desi Bites table. To compute WACC, we used the market value of equity — which came from the share price. But the entire purpose of computing WACC is to discount cash flows and arrive at… a value for the equity.

So the input depends on the output. That’s genuinely circular, and it isn’t a mistake in this post — it’s an acknowledged awkwardness in the standard method. In practice people use the current market capitalisation and accept the circularity, or iterate until the numbers settle, or use a target capital structure instead of the current one.

It’s worth knowing about, because it undercuts any claim that a DCF is independent of market prices. The market price usually leaks into the model through this door.

Common mistakes

  • Using book value weights instead of market values. Book equity is a historical accounting artefact. WACC is about what capital costs now, and for a listed company that means market capitalisation.
  • Forgetting the tax shield on debt. Skip the (1 − t) and you overstate WACC, which understates the valuation. It’s a small term in an equity-heavy company and a large one in a leveraged company.
  • Reaching for precision the inputs can’t support. The equity risk premium is an estimate with a range of several percentage points, and beta shifts depending on the period and index you regress against. A WACC quoted as “13.91%” is a convenient handle for a genuinely fuzzy number, not a measurement — this series carries the two decimals only so the arithmetic reconciles.
  • Applying one company’s WACC to a different company. Costs of capital are specific to the borrower and its risk. Britannia’s cost of debt isn’t available to Desi Bites, and that difference is the point.
  • Using WACC to discount cash flows meant for shareholders alone. WACC is the blended cost of all capital, so it pairs with cash flows available to all capital providers — free cash flow to the firm, which the next post builds. Pair it with equity-only cash flows and you’ve double-counted the debt.

Takeaway: WACC blends what shareholders demand with what lenders charge, weighted by how much of each the company uses and adjusted for the tax deduction on interest. For an equity-heavy business it lands within a whisker of the cost of equity — and since that number rests on an estimated risk premium and a backward-looking beta, the honest way to hold a WACC is as a plausible range, not a figure to two decimal places.