The Weighted Average Cost of Capital (WACC) is a crucial metric in corporate finance, representing the average rate of return a company is expected to pay to all its different security holders (both debt and equity) to finance its assets. It is most frequently used as the discount rate in a Discounted Cash Flow (DCF) valuation model to determine a company’s intrinsic value.
A lower WACC is generally favorable, as it indicates lower financing costs and suggests the company can create value more easily.
The WACC Formula
WACC is a weighted average that combines the costs of a company’s different sources of capital—primarily equity and debt—based on their proportion in the company’s capital structure.
The standard formula for WACC, considering only debt and common equity, is:
$$WACC = \left( \frac{E}{V} \times r_e \right) + \left( \frac{D}{V} \times r_d \times (1-T_c) \right)$$
Where:
| Variable | Description |
| $\frac{E}{V}$ | Weight of Equity: The proportion of equity in the total capital structure. |
| $\frac{D}{V}$ | Weight of Debt: The proportion of debt in the total capital structure. |
| $r_e$ | Cost of Equity: The return required by equity investors. |
| $r_d$ | Cost of Debt (Pre-Tax): The interest rate a company pays on its debt. |
| $T_c$ | Corporate Tax Rate: The company’s effective marginal tax rate. |
| $V$ | Total Market Value of Capital: $V = E + D$ |
Step 1: Calculate the Components
Calculating WACC involves determining four key inputs: the cost of each capital source and its market weight.
1. Cost of Equity
The cost of equity is the return investors expect for bearing the risk of owning the company’s stock. It is typically calculated using the Capital Asset Pricing Model (CAPM):
$$r_e = r_f + \beta \times (r_m – r_f)$$
Where:
- $r_f$: Risk-Free Rate (e.g., the yield on a long-term government bond).
- $\beta$: Beta (a measure of the stock’s volatility relative to the overall market).
- $(r_m – r_f)$: Equity Risk Premium (the expected excess return of the market over the risk-free rate).
2. Cost of Debt
The cost of debt is the interest rate a company pays on its borrowings. This is usually estimated as the Yield-to-Maturity (YTM) on the company’s existing long-term debt or bonds. Unlike equity, interest payments on debt are tax-deductible, creating a “tax shield.” This is why we use the After-Tax Cost of Debt in the WACC formula:
$$\text{After-Tax Cost of Debt} = r_d \times (1 – T_c)$$
3. Market Values and Weights
The weights in the WACC formula should be based on the market values of debt and equity, not the book values, as they reflect current market perceptions of the company’s risk and value.
- Market Value of Equity ($\boldsymbol{E}$): Market capitalization (Current Stock Price $\times$ Number of Outstanding Shares).
- Market Value of Debt ($\boldsymbol{D}$): The sum of the market values of all outstanding debt (e.g., face value of bonds adjusted for current market prices).
- Total Value ($\boldsymbol{V}$): $V = E + D$.
The weights are then calculated as:
- $\text{Weight of Equity} = \frac{E}{V}$
- $\text{Weight of Debt} = \frac{D}{V}$
4. Corporate Tax Rate
This is the company’s marginal corporate tax rate (the tax rate on the next dollar of taxable income). It is used to calculate the after-tax cost of debt.
Step 2: The Calculation Example
Let’s assume the following data for a hypothetical company, XYZ Corp:
| Component | Value |
| Market Value of Equity ($\boldsymbol{E}$) | $\$500 \text{ million}$ |
| Market Value of Debt ($\boldsymbol{D}$) | $\$300 \text{ million}$ |
| Cost of Equity ($\boldsymbol{r_e}$) | $10.0\%$ |
| Cost of Debt ($\boldsymbol{r_d}$) | $6.0\%$ |
| Corporate Tax Rate ($\boldsymbol{T_c}$) | $25\%$ (or $0.25$) |
1. Calculate Total Value:
$$V = E + D = \$500 \text{ million} + \$300 \text{ million} = \$800 \text{ million}$$
2. Calculate Weights:
- $\frac{E}{V} = \frac{\$500 \text{ million}}{\$800 \text{ million}} = 0.625$ (or $62.5\%$)
- $\frac{D}{V} = \frac{\$300 \text{ million}}{\$800 \text{ million}} = 0.375$ (or $37.5\%$)
3. Calculate After-Tax Cost of Debt:
$$\text{After-Tax } r_d = 6.0\% \times (1 – 0.25) = 6.0\% \times 0.75 = 4.5\%$$
4. Calculate WACC:
$$WACC = (\text{Weight of Equity} \times r_e) + (\text{Weight of Debt} \times \text{After-Tax } r_d)$$$$WACC = (0.625 \times 10.0\%) + (0.375 \times 4.5\%)$$$$WACC = 6.25\% + 1.6875\%$$$$WACC = 7.9375\%$$
The Weighted Average Cost of Capital (WACC) for XYZ Corp is approximately $7.94\%$. This means the company must generate a return of at least $7.94\%$ on its investments just to cover its financing costs.
Why is the Cost of Debt Tax-Adjusted?
The after-tax adjustment for debt is critical. Interest payments are a business expense that is deductible from a company’s taxable income, effectively reducing the company’s tax burden. This tax shield makes debt a cheaper source of financing compared to equity, which offers no such deduction.
