WACC Formula
This article outlines what WACC is, it's formula, and what it's used for in corporate finance.
Definition of WACC
A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including preferred shares, common shares, and debt. The cost of each type of capital is weighted by its percentage of total capital (debt to equity ratio).
WACC is used in financial modeling as the discount rate to calculate the value of the business.
What is the WACC formula?
Below is the equation for WACC:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where:
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate
Cost of Equity
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which equates rates of return to volatility (risk vs reward). Below is the formula for the cost of equity:
Re = Rf + β × (Rm − Rf)
Where:
Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield)
β = equity beta (levered)
Rm = annual return of the market
The cost of equity is an implied cost, or an opportunity cost of capital. It is the rate of return shareholders require in order to compensate them for the risk (volatility) of investing in the stock (in theory). The Beta is a measure of a stock’s volatility of returns relative to the whole market index (such as the S&P 500). It can be calculated by downloading historical return data from Bloomberg or using the WACC and BETA functions.
Cost of Debt
Take the weighted average current yield to maturity of all outstanding debt. The cost of debt is then multiplied one minus the tax rate because of the tax shield created by deducing interest expense from taxable income.
What is WACC used for?
The Weighted Average Cost of Capital (WACC) serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunity cost.
A company will commonly use it’s WACC as a hurdle rate for evaluating mergers and acquisitions as well financial modeling of internal investments. If an investment opportunity has a lower Internal Rate of Return (IRR) than it’s WACC, it should buy back its own shares instead of investing in the project.
Nominal vs Real
Nominal free cash flows (including inflation) should be discounted by a nominal rate and real free cash flows (excluding inflation) by a real rate. Nominal is most common in practice, but it’s important to be aware of the difference.
Career paths
Many professionals /analysts in corporate finance use WACC in their day-to-day jobs. Some of the main careers that use WACC in financial analysis include:
To find out more check out our interactive Career Map.