WACC vs Cost of Equity: Which Discount Rate to Use and When
By Devon Coombs, CPA, MBA · Teaching Professor of Finance, Santa Clara University · Reviewed August 2026
Discount free cash flow to the firm at WACC, which produces enterprise value, then subtract net debt to reach equity value. Discount free cash flow to equity at the cost of equity, which produces equity value directly. The discount rate must match the cash flow stream, because each rate compensates a different set of claimholders.
| WACC | Cost of equity | |
|---|---|---|
| Matching cash flow | Free cash flow to the firm | Free cash flow to equity |
| Valuation output | Enterprise value | Equity value |
| Key inputs | Cost of equity, after-tax cost of debt, target weights | Risk-free rate, levered beta, equity risk premium |
| Interest tax shield | Captured in the after-tax cost of debt | Captured in the cash flows through interest deductions |
| Relative level | Generally below the cost of equity for a levered firm | Generally the highest required return in the structure |
| Common model | Enterprise DCF, acquisition analysis | FCFE model, dividend discount model |
When WACC is the right tool
WACC is the right rate for an enterprise DCF, where the cash flows belong to all capital providers and the output is the value of the whole operating business. It suits acquisition analysis and any valuation where capital structure may change, since target weights can be set once rather than modeled year by year. Practitioners typically weight equity and debt at market values and at a target structure, not at book values. For a private company, the standard approach unlevers the betas of comparable public firms and re-levers them at the subject company's target structure before the cost of equity enters the blend.
When Cost of equity is the right tool
The cost of equity is the right rate when the cash flows are already the residual claims of shareholders, as in a free cash flow to equity model or a dividend discount model. It tends to be the cleaner choice for banks and other financial firms, where debt functions as an operating input and enterprise value is hard to define. It is generally the highest rate in the capital structure, since equity absorbs losses first. FCFE models grow fragile when leverage shifts year to year, because the equity beta and the cash flows both move with the debt schedule.
The common mistake
The frequent error is discounting equity cash flows at WACC because WACC is treated as the company's all-purpose discount rate. For a levered firm, WACC generally sits below the cost of equity, so the mismatch inflates equity value, and the symmetric error of discounting firm cash flows at the cost of equity understates enterprise value. A related slip double counts the interest tax shield by using the after-tax cost of debt in WACC while also deducting interest inside the cash flows being discounted. Free cash flow to the firm is computed before financing, so interest never belongs in it.
Work the numbers yourself
Both concepts are taught in depth, with practice questions, in the free Entrepreneurial Finance course.