The Weighted Average Cost Of Capital

When I was fresh out of college in the mid-90s, I landed a job at Merrill Lynch. I was an "investment banking analyst", which meant I had no life outside of the office and hardly ever slept. I pretty much spoke, thought, and dreamed in Excel during those years.
Much of my time there was spent building valuation models. These complicated spreadsheets were used to provide an air of quantitative validation to the answers the senior bankers otherwise pulled out of their derrieres to questions like: Is the market under- or over-valuing this company? Can we defend the acquisition price we're recommending for this M&A deal? What should we price this IPO at?
Back then, Wall Street still (mostly) believed that fundamentals mattered. And one of the most widely-accepted methods for fundamentally valuing a company is the Discounted Cash Flow (or "DCF") method. I built a *lot* of DCF models back in those days.

I promise not to get too wonky here, but in a nutshell, the DCF approach projects out the future cash flows a company is expected to generate given its growth prospects, profit margins, capital expenditures, etc. And because a dollar today is worth more than a dollar tomorrow, it discounts the further-out projected cash flows more than the nearer-in ones. Add everything up, and the total you get is your answer to what the fair market value of the company is.

The Weighted Average Cost Of Capital

The DCF approach sounds pretty straightforward. And it is. But it's still much more of an art than a science. Your future cash flow stream is entirely dependent on the assumptions you bake into the model. The difference between a 5% or 15% assumed EBITDA compound annual growth rate becomes huge when projecing over 10+ years.

But one assumption in the model has far more impact on the final valuation number than any other. And it has nothing to do with the company’s projected operations.

Recall that the DCF approach projects out the expected future cash flows, and then discounts them (back to what’s called a “present value”). This raises a critically important question:

At what rate do you discount these future cash flows?

Well, to address this, you need to ask yourself a few questions. How will the company be financing itself? It will need to deliver an acceptable return to both its stockholders and bondholders. What kind of return can investors get out in the market for a similar investment? If they can get a better expected rate of return, or similar return with less risk, they’ll put their money elsewhere.

Enter a calculation known as the Weighted Average Cost Of Capital (or “WACC”). Again, without getting too technical on you, the WACC looks at how a company is capitalized (what % with debt, what % with equity) and what blended annual rate of return the investors who contributed that capital expect. Once you’ve calculated the WACC, you put that number into your DCF model as the annual discount rate and – Voilà! – your model spits out the present value for the company.

It's All About The "Risk Free" Rate

So, to recap:
  1. Companies (really, any asset with an income stream) are valued off of the present value of their discounted future cash flows
  2. This present value is highly dependent on the discount rate used
We just talked about how the WACC is commonly used as the discount rate (or, at least, its foundation). So how is the WACC calculated?

Here’s its formula (Don’t let it scare you; I’m not going to get all mathy on you here):

I want to point your attention to two important factors in this equation: the cost of equity (re) and the cost of debt (rd). The size of these variables has a big impact on the final number calculated for the WACC.

Re, the cost of equity, is made up of two components: the market’s current “risk free rate” + the “equity premium” that investors demand on top of that to hold stocks, which have more risk. Most folks use the current yield on the 10-year US Treasury bond as the risk free rate (which has hovered around 2% for the past several years).

Similarly, rd, the cost of debt, has two components: the market “risk free rate” + the premium that the company’s bondholders are charging to hold debt riskier than a Treasury bond.

The really important thing to understand here is that both of these variables are dependent upon interest rates (most notably, the yield on the 10-year Treasury). As interest rates rise, the cost of equity goes up, and the cost of debt goes up, too.

Why is that so important? Glad you asked…

The Future Of Rising Rates (And Falling Asset Prices)

Most reading this are aware that we've been living in a falling interest rate environment for most, if not all, of our adult lives. And since the 2008 financial crisis, interest rates have been held down at essentially 0% (or even lower) by the world's central banks:


While not the only reason, this decline in interest rates has been a huge driver behind the tremendous rise in valuations across assets like stocks, bonds and real estate over the past 30-odd years.

Which begs the question: What will happen to asset prices if/when interest rates start rising again?

Well, as I hope the above lesson on the Weighted Average Cost Of Capital hammered home, when the core interest rate rises, both the cost of equity and the cost of debt go up. Mathematically, this increases the WACC used as a discount factor, thereby reducing the present value of future cash flows. Or in layman’s terms: When interest rates rise so does the WACC, which mathematically makes valuations fall.

Now, we only need to care about this if we’re worried that interest rates will start rising. Maybe the central banks have everything under control. Maybe we’re at a “permanent plateau” of sustainable zero-bound interest rates.

Oops; or maybe not.

Remember how the “risk free rate” used in calculating the WACC is often the 10-year Treasury bond yield? Well, the yield on the 10-year Treasury started spiking last month, and is currently nearly double(!) what is was just five short months ago:


Now, it takes a little while for the higher cost of capital to ripple through the system. But we’re already seeing some immediate effects, with numerous warnings of future price corrections multiplying in today’s headlines.

Given their strict see-saw relationships with interest rates, bond prices are getting slammed:

U.S. Government: Bond Prices Fall as 10-Year Yield Hits 2016 High

Renewed selling pressure Thursday resulted in the yield on the benchmark 10-year Treasury closing at its highest since late December, wiping out the big drop earlier this year.
The yield premium that investors demanded to own the 10-year U.S. Treasury note relative to the 10-year German bund climbed to 1.99 percentage point late Thursday, the highest since 1989, the year the Berlin Wall fell. The U.S. 10-year note’s yield premium relative to the 10-year Japanese government bond also rose to the highest since January 2014.

Bond Market Slide Intensifies

Rise in yields since July has pushed the 10-year Treasury note up by more than 1 percentage point

The worst bond rout in three years deepened Thursday, hammering debt issued in emerging markets and many U.S. states and cities, while sparing large companies the brunt of the impact.
The yield on the 10-year Treasury note rose to a 17-month high, at 2.444%, up from 2.365% on Wednesday. Yields rise as bond prices fall.
The housing market has a similar see-saw relationship with interest rates, but given how less liquid homes are than bonds, it will take more time before the recent rate causes a noticeable effect on prices. That said, as expected, we are seeing an immediate impact on the market for home refinancing loans:

Mortgage Refinancings Collapse To 2016 Lows As Rates Top 4.00%

Mortgage applications tumbled 9.4% from the prior week as mortgage rates soared above 4.00% to the highest level since July 2015. The biggest driver of the decline in mortgage demand was a 16% crash in refinances - tumbling to their lowest level since the first week of January
And the industry is bracing for a pullback as "shocked" consumers react to the spike in rates:
US Housing Market In Peril As "Increase In Mortgage Rates Has Shocked Consumers"

Eventually, though, rising rates make houses less affordable, and that could lead to slowing sales, price growth and mortgage activity. Some analysts are now projecting home values will decline by the end of next year in many U.S. housing markets.

The MBA lowered its projections for next year’s new mortgage loans by 3% last week, to $1.58 trillion. That would represent a 16% drop from the nearly $1.9 trillion in mortgages that lenders are on pace to originate this year, with refinancing accounting for all of the drop.

“The increase in rate has shocked consumers…I didn’t expect it either,” said Dave Norris, chief revenue officer at LoanDepot, the 10th largest mortgage lender in the U.S. by loan volume.


Equities have yet to soften due to the rise in rates, but the recent rally kicked off by the recent Presidential election appears to have run out of steam. More importantly, an increasing chorus of venerated investors is warning that even higher rates are coming -- soon. And with them, a market correction:
Druckenmiller Joins Gundlach In Predicting 6% Yields; Expects Market Correction As Rates Rise
Druckenmiller joined Jeff Gundlach in predicting that US 10Y yields may rise to 6% over the next year or two (...)
(...) he echoed the warning made just last night by Goldman Sachs, according to which a 10Y above 2.75% would put pressure on stocks, and said that if the 10Y rose to 3%, the S&P could see a 10% correction, but warned that the market could correct well prior to that in anticipation.
Even the newly-selected Treasury Secretary Steve Mnuchin agrees that higher rates are an approaching inevitability:
“We’ll look at potentially extending the maturity of the debt, because eventually we are going to have higher interest rates, and that’s something that this country is going to need to deal with."


Prepare Now

The conclusion from all the above? Get ready to live in an era of rising interest rates. It's going to be unfamiliar territory for all of us...

What will likely happen? The unrelenting upward march in asset prices we've enjoyed over the past several decades is over. People won't be able to pay as much for stuff because the financing costs will be higher.

Falling asset prices should be in the cards. We're already seeing that with bonds, and housing and stocks should follow over the next few quarters. The higher rates go, the farther the fall should be.

The Fed will be in a tough spot as this unfolds. Right now, the Fed has little power to slow things down, as the core interest rate it sets is already nearly 0%. It will likely raise rates as it can along with the market, provided it can do so without killing the economy. There's a lot of precedent for this; historically, the Fed's interest rate has usually followed the market vs leading it. The Fed will want to gain some maneuvering room to drop rates at some point in the future if it feels it needs to.

At some point, if we risk entering a full deflationary rout, the world's central planners may well indeed pull out an arsenal of tricks similar to what we saw following the 2008 crisis. We may eventually see liquidity-injection programs so extreme that hyperinflation becomes a valid concern. But that time is not now.

For now, we recommend getting out of debt. Especially variable rate, non-self-liquidating debt (credit cards being a great example). As we've said many times, in periods of deflation, debt can be a stone-cold killer.

Be sure to have positioned your financial portfolio to take into account the risks to stocks/bonds/etc raised here. Read our primer on hedging. Read the Financial Capital chapter from our book Prosper! (we've made it available to read for free here). Talk with our endorsed financial adviser (again, free of charge) if you're having difficulty finding a good one to discuss this topic with.

And to really understand what life will be like as interest rates turn from a tailwind into a headwind for the global economy, read this report we published earlier this year, when the markets first buckled in 2016.

In Part 2: Why This Next Crisis Will Be Worse Than 2008 we look at what is most likely to happen next, how bad things could potentially get, and what steps each of us can and should be taking now -- in advance of the approaching rout -- to position ourselves for safety (and for prosperity, too).

Click here to read Part 2 of this report (free executive summary, enrollment required for full access)

This is a companion discussion topic for the original entry at

“Falling asset prices should be in the cards. We’re already seeing that with bonds, and housing and stocks should follow over the next few quarters. The higher rates go, the farther the fall should be.”
So given Jim Rickards post election prediction on the Gold price in the recent podcast seems to be incorrect, is it now time to consider Gold could go lower still, like Harry Dent has been forecasting?

Assuming a free market, which we don’t really have, the following should be true:
Two things cause prices of a commodity or product to rise. A shortage of supply compared to demand, or adding more money into the system for the same amount of goods.
If the commodity for sale is money (aka debt) there are also two factors primarily affecting the price. If the demand for money is high (driven by excess energy and demand in the productive economy) the buyers will pay a higher price to access the money. Or, if the risk of repayment is high, then the seller of money can demand more from the buyer.
All of the above assumes money is like a commodity; i.e.that it has to exist before it is sold.
In our current not so free money market system governments try to buy GDP (aka economic growth) by offering debt for sale. In doing so they create money by fiat.
What is really for sale is the natural resources (including fuels if they are available resources) and the future human labor’s productivity of that country. If the risk of repayment is low because underlying conditions support economic growth then they can sell the risk of this debt for less. As the risk of repayment rises, so does the cost. The risk of repayment stays low only if the economy actually grows. If the economic growth is weak then the risk cost (aka interest) rises.
In a competitive world market countries pay according to the perceived risk.
All of the above works until there is no economic growth. At this point the government and its codependent central bank have nothing worth buying for sale at any price. All that is left is the seed corn (aka the remaining real wealth of the productive citizens). Nobody wants to be seed corn.
So where are we in this interest rate rise? It might well be the KAAAA before the Boom.
Is it time to get most of our seed corn away from the clawback of the system? For us measly citizens that is our best bet.

Here's a frightening series of stats I posted on the site a year and a half ago (so you can bump the percentages up a bit):

A new report by Bloomberg shows that the average Wall Street trader is 30 years old. Given that:
  • 30% of traders are so young they have NEVER experienced anything other than zero interest rates.
  • 66% of traders have no adult memory of the dot-com crash of 2000.
  • Only 43% of traders are old enough to remember the 2000 dot-com crash and the 2007 credit crisis — the two most significant economic cycles of the last 15 years.

Simply put, the majority of humans responsible for trading – or coding the algorithms that trade – in our financial markets have very little experience doing so in an environment of rising interest rates. Or put another way, as interest rates begin to rise (as they must do for one reason or another), the traders in control of our system are uniquely unqualified. All their muscle memory has been developed with the tailwind of a liquidity-happy Fed at their backs. When that tailwind switches to a headwind…

What could go possibly go wrong?

Read the entire Bloomberg article here

My living memory goes beck to the thrill of Jimmy Carter and gas lines and 21% mortgages. Since I’ve never been a trader there is no muscle memory there. However, as has often been said on this site, this time is different.
The most recent efforts to flog this economy back to a trot with low, low interest rates have failed. People and countries have bought lots and lots of bonds. Still no trot.
This time feels quite different. I wouldn"t be surprised to see our horse lie down in the road and dump the wagon over on top of us. Last time that happened was 1930. Nobody’s got muscle memory fom then.

Can’t see interest rates going up any time soon. They might try, see the economy tank as people fail to make their interest payments as a consequence, then bring them down again, pronto.
The sequence of events is as follows: firstly growth falters, then debts become unmanageable, then debts (and savings) get obliterated by a period of high inflation (with the help of helicopter money if need be), then and only then do interest rates rise.

climber –
You're thinking of interest rates as set by the Fed. But as I mention in the above piece, historically the Fed's rate setting has followed the market's direction, not led it.

We may be witnessing the return of a key market participant who's been absent for a long time: the bond vigilante. From Wikipedia:

bond vigilante is a bond market investor who protests monetary or fiscal policies he considers inflationary by selling bonds, thus increasing yields.

In the bond market, prices move inversely to yields. When investors perceive that inflation risk or credit risk is rising they demand higher yields to compensate for the added risk. As a result, bond prices fall and yields rise, which increases the net cost of borrowing. The term references the ability of the bond market to serve as a restraint on the government's ability to over-spend and over-borrow.

Right now, investors are indeed selling bonds and sending yields higher.

That increases the 10-year Treasury "risk free" rate, thus increasing the WACC. This drops the prices of bonds, stocks, real estate (and any asset with an income stream). Once those losses start to ripple through the system in earnest, the payment defaults and economic slowdown you mention will be off to the races.

Yep, could be. The bond vigilantes have been very quiet lately, that’s for sure. I need to do more research on the bond vigilantes. Don’t they crash individual countries though? How do they make a profit if they crash the whole system? As I say, I need to do some more thinking of my own before I come to a conclusion on this one.

The reason the long rates are rising is not because of an increase in overall supply of bonds, but because a fair number of current long-duration bondholders suddenly decided they want to sell; this means there are more sellers than buyers at the current price (rate), so price drops (rates rise) until the buyer-seller balance equalizes again.

All the previously-issued bonds remain at their old coupons, so this has no immediate effect on companies or the government, but any new bond issues will have to be issued at the new, higher rates.  The effect of a bond-market rate increase is gradual because of this - most bonds currently out there were issued long ago.

The Bond Vigilantes are not some organized cabal of financial revolutionaries, they are just bondholders who get scared when they see inflation is coming, and so they panic out of their bonds in anticipation of this higher inflation.  If you scare bondholders, you get higher long bond rates, and that tends to slow the economy.  "Don't scare the bondholders."  Its why James Carville said he wanted to be reincarnated as the bond market - "because you can intimidate everybody."

The Fed has bought a lot of bonds, but if the vast majority of bondholders believe that real inflation will rise from 3% to 6% in the near future (however you measure that), then if the Fed wants to keep the 10 year at 3%, they're going to have to buy every single bond in existence as the current holders panic out of them.

Likewise, new corporate bond coupons will jump higher too - nobody will sign up to buy a 4% corporate when they expect 6% inflation, so the coupon will have to rise to tempt people to buy them.  Unless, of course, the Fed buys all of those too.

DaveF wrote:

The Bond Vigilantes are not some organized cabal of financial revolutionaries, they are just bondholders who get scared when they see inflation is coming, and so they panic out of [by selling] their bonds in anticipation of this higher inflation.  If you scare bondholders, you get higher long bond rates, and that tends to slow the economy.  "Don't scare the bondholders."
Thank you so much for making this often used term accessible to me.  Previously it has always been a bit vague and utterly non-intuitive. 

Now, I get it.


The total value of all bond markets is enormous.  As the Chinese and many US investors sell their bonds, where will all this money go?  Some of the money will shift to shorter duration bonds. But where will most of it end up? 

The available gold and silver is a rounding error compared to the value of all bonds. Real estate - farmland, commercial, residential, or rental - are all overpriced for a rising rate environment.  Does that leave us with extremely overvalued bond money moving into overvalued equities?  Armstrong indicates that scared money from around the planet flows into equities.  Do you think he has it right this time?




The Italian vote is today and there has been a been of a "vote" by the bond vigilantes, such as they are.
The Italian ten year is now trading at a relatively (recently speaking) wide spread to German bunds and they have sold off pretty hard over the past month driving Italian yields up.

Perhaps all of that simply means a possible "no" vote today is already baked in the cake, but if not, then I think we might see what a bond vigilante is first in the Italian drama that is unfolding.


I am not the guy who can envision in his mind what parts move and which ones turn in an 8 speed automotive transmission… The market has a lot of moving parts and underlying reasons, some seen, some not seen, that motivate buyers and sellers. I do simplify to the point of error. Thanks for your input. On a slightly different note–What role in the speed of change can we expect from the algo driven ‘bond vigilante bots’? They weren’t around last time interest rates were running up.

A little off topic but my main interest is the very big picture.  Why did interest rates peak in the 70's ?

My thesis is that in the 70's, growth in GDP started to falter. In order to maintain growth we literally started to borrow GDP from the future.  Therefore debt exploded and correspondingly interest rates dropped. We sustained the unsustainable - for a bit.  Eventually the present catches up to the future - bang.  The result is that GDP will now follow a Seneca curve (like a bell shaped curve but where the trailing edge falls precipitously as in "off a cliff") instead of a symmetrical bell shaped curve we were following before the 70's.

My sense is that the bots just follow the current trend, whatever it is.  (That's the secret to trading success: trend following)
The trend setters will be the big money that decides to either buy or sell in a big way.  The bots may keep the trend going for longer, but I don't think they have enough money to set the trend on their own.

One issue is a lower amount of liquidity than in the past.  This might suggest that if things get disorderly (i.e. there is a LOT of selling all at once) we might see a bond flash crash.  We've already seen that in the currencies during difficult times.  I'd say that would be the biggest impact from the bots.  Bid is there, and then suddenly it isn't because the bot recoils in horror from something it sees and yanks the bids.

Of course its hard to really know.  Most of these systems work great right up until they don't.  As a software guy, I test my code against the cases that I can think of - and then I release the code, and then the real world causes problems that I didn't think of, I get a bug report, and then I fix that bug.  Do this bugfix-release cycle for a couple of years, and you have a fairly reliable software system.

But then something new comes along - some big crash of some sort - that's a new bug.

A system is a lot like that.  They can only fix problems they've actually seen before.  By definition, its reactive.

And so we take our old bond market, add in automated trading, we reduce the amount of inventory in the market makers, we introduce the Fed as an "extra" player, and then we layer on "the top of a 35 year bull market in bonds" … I'm not sure they've tested all those cases.

As Adam said, last time we had a real bear market in bonds was in the 70s.  System looked a whole lot different back then…

When the money leaves the bond market, it for sure has to go somewhere.  My guess, initially, will be just bank deposits and or very short term money.
The panic Armstrong is talking is more than just about interest rates.  At least, I think its more than just about rates.  Take this scenario.

Step 1: Today, buy a 20 year Italian Euro treasury bond, yielding (say) 3%.  Value = 100 (1 USD=1.05 Euro)

Step 2: In 2017, Italy leaves the EU.  Your bond is now an Italian LIra treasury bond.  Value = 52 (1 USD=2 Lira)

Step 3: Rates for Italian debt skyrocket to 10%.   That's a 70% hit to your 3% bond.  Value = 15.

Step 4: With rates at 10%, Italian debt is unpayable; Italy defaults.  Bond principal chopped by 50%.  Value = 7.5.

Total loss: 92%, in USD terms.

Kinda makes equities look good.  They are, at least, mostly insulated from changes to the currency, because (typically) equities reflect ownership of real things - assuming the underlying company is a "real things" company rather than, say, a bank.


What if the government just lends itself money and buys all the bonds?  External buyers don't matter any more.  Problem solved.  Bond prices don't crash;. and that's what we are doing now, right?  Isn't that the end game? The government gets to own all the bonds, sort of Nationalization by the back door, end of the market, effectively?  What stops this scenario from happening? Do the bond vigilantes have enough firepower to fight the government's printing press?
Questions, questions! 

Love your comment, by the way.  Your example was very clear.


Here are some more questions. Can the government maintain current nominal bond and equity prices indefinitely (by intervening in the market) and just let inflation take care of things?  After 10 years of say 7% inflation pa, bond and equity prices will have halved in real price. Is this just the definition of "stagflation"? 

All of this convinces me further that the global system can not possibly falter slowly, nor slide gently downward, as previous systems/civilizations have in the past. This time is different; not in the underlying forces of entropy, nor in the overarching causes of decline - those are pretty universal across time and place in history - but rather because the system of global civilization we currently live in is far more massive and complex than any civilization ever has been. If the complexity of a system runs in direct relation to the speed of its fall and spectacular-ness of its implosion, which as far as I know about declines and collapses in history seems to be the case, then this decline will be far more rapid and far more spectacular than we've ever witnessed. I know I've said it before, but reading these posts gives me insight into just how massively complex our current fiscal world is. 

Dave, thanks again for making the complex accessible. It helps greatly.


Its also interesting that they label these people "vigilantes," which implies a sort of nefarious motive to them, when in fact they appear to just be investors acting out of reasonable self-interest. They are only "vigilantes" when viewed from the perspective of those who want to control how the market behaves - the elite. 

I thought they were a rock'n'roll band from the UK or something.
And I am very disappointed to learn that the Bond Vigilantes don't have a secret handshake and meet in the basement of a pub somewhere after closing time…