A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capitalCost of CapitalCost of capital is the minimum rate of return that a business must earn before generating value. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of funding its operation. across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added together. This guide will provide a detailed breakdown of what WACC is, why it is used, how to calculate it, and will provide several examples.
WACC is used in financial modelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model. as the discount rate to calculate the net present valueNet Present Value (NPV)Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present. of a business.
E = market value of the firm’s equity (market capMarket CapitalizationMarket Capitalization (Market Cap) is the most recent market value of a company’s outstanding shares. Market Cap is equal to the current share price multiplied by the number of shares outstanding. The investing community often uses the market capitalization value to rank companies) 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 returnRequired Rate of ReturnThe required rate of return (hurdle rate) is the minimum return that an investor is expecting to receive for their investment. Essentially, the required rate of return is the minimum acceptable compensation for the investment’s level of risk.) Rd = cost of debt (yield to maturity on existing debt) T = tax rate
An extended version of the WACC formula is shown below, which includes the cost of Preferred Stock (for companies that have it).
The purpose of WACC is to determine the cost of each part of the company’s capital structureCapital StructureCapital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm's capital structure based on the proportion of equity, debt, and preferred stock it has. Each component has a cost to the company. The company pays a fixed rate of interestInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also on its debt and a fixed yield on its preferred stock. Even though a firm does not pay a fixed rate of return on common equity, it does often pay dividendsDividendA dividend is a share of profits and retained earnings that a company pays out to its shareholders. When a company generates a profit and accumulates retained earnings, those earnings can be either reinvested in the business or paid out to shareholders as a dividend. in the form of cash to equity holders.
The weighted average cost of capital is an integral part of a DCF valuation modelDCF Model Training Free GuideA DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow and, thus, it is an important concept to understand for finance professionals, especially for investment bankingInvestment BankingInvestment banking is the division of a bank or financial institution that serves governments, corporations, and institutions by providing underwriting (capital raising) and mergers and acquisitions (M&A) advisory services. Investment banks act as intermediaries and corporate developmentCorporate DevelopmentCorporate development is the group at a corporation responsible for strategic decisions to grow and restructure its business, establish strategic partnerships, engage in mergers & acquisitions (M&A), and/or achieve organizational excellence. Corp Dev also pursues opportunities that leverage the value of the company’s business platform. roles. This article will go through each component of the WACC calculation.
WACC Part 1 – Cost of Equity
The cost of equity is calculated using the Capital Asset Pricing Model (CAPM)Capital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of a security. CAPM formula shows the return of a security is equal to the risk-free return plus a risk premium, based on the beta of that security 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 equityCost of EquityCost of Equity is the rate of return a shareholder requires for investing in a business. The rate of return required is based on the level of risk associated with the investment is an implied cost or an opportunity cost of capital. It is the rate of return shareholders require, in theory, in order to compensate them for the risk of investing in the stock. The Beta is a measure of a stock’s volatility of returns relative to the overall market (such as the S&P 500). It can be calculated by downloading historical return data from Bloomberg or using the WACC and BETA functionsBloomberg Functions ListList of the most common Bloomberg functions and shortcuts for equity, fixed income, news, financials, company information. In investment banking, equity research, capital markets you have to learn how to use Bloomberg Terminal to get financial information, share prices, transactions, etc. Bloomberg functions list.
Risk-free Rate
The risk-free rateRisk-Free RateThe risk-free rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the risk-free rate is commonly considered to equal to the interest paid on a 3-month government Treasury bill, generally the safest investment an investor can make. is the return that can be earned by investing in a risk-free security, e.g., U.S. Treasury bonds. Typically, the yield of the 10-year U.S. Treasury10-Year US Treasury NoteThe 10-year US Treasury Note is a debt obligation that is issued by the US Treasury Department and comes with a maturity of 10 years. is used for the risk-free rate.
Equity Risk Premium (ERP)
Equity Risk PremiumEquity Risk PremiumEquity risk premium is the difference between returns on equity/individual stock and the risk-free rate of return. It is the compensation to the investor for taking a higher level of risk and investing in equity rather than risk-free securities. (ERP) is defined as the extra yield that can be earned over the risk-free rate by investing in the stock market. One simple way to estimate ERP is to subtract the risk-free return from the market return. This information will normally be enough for most basic financial analysis. However, in reality, estimating ERP can be a much more detailed task. Generally, banks take ERP from a publication called Ibbotson’s.
Levered Beta
BetaBetaThe beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns. refers to the volatility or riskiness of a stock relative to all other stocks in the market. There are a couple of ways to estimate the beta of a stock. The first and simplest way is to calculate the company’s historical beta (using regression analysisRegression AnalysisRegression analysis is a set of statistical methods used to estimate relationships between a dependent variable and one or more independent variables.) or just pick up the company’s regression beta from Bloomberg.
The second and more thorough approach is to make a new estimate for beta using public company comparablesComparable Company AnalysisThis guide shows you step-by-step how to build comparable company analysis ("Comps") and includes a free template and many examples.. To use this approach, the beta of comparable companies is taken from Bloomberg and the unlevered beta for each company is calculated.
Levered beta includes both business risk and the risk that comes from taking on debt. However, since different firms have different capital structures, unlevered betaUnlevered Beta / Asset BetaUnlevered Beta (Asset Beta) is the volatility of returns for a business, without considering its financial leverage. It only takes into account its assets. (asset beta) is calculated to remove additional risk from debt in order to view pure business risk. The average of the unlevered betas is then calculated and re-levered based on the capital structure of the company that is being valued.
In most cases, the firm’s current capital structure is used when beta is re-levered. However, if there is information that the firm’s capital structure might change in the future, then beta would be re-levered using the firm’s target capital structure.
After calculating the risk-free rate, equity risk premium, and levered beta, the cost of equity = risk-free rate + equity risk premium * levered beta.
Determining the cost of debtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis. and preferred stock is probably the easiest part of the WACC calculation. The cost of debt is the yield to maturity on the firm’s debt and similarly, the cost of preferred stock is the yield on the company’s preferred stock. Simply multiply the cost of debt and the yield on preferred stock with the proportion of debt and preferred stock in a company’s capital structure, respectively.
Since interest payments are tax-deductible, the cost of debt needs to be multiplied by (1 – tax rate), which is referred to as the value of the tax shieldTax ShieldA Tax Shield is an allowable deduction from taxable income that results in a reduction of taxes owed. The value of these shields depends on the effective tax rate for the corporation or individual. Common expenses that are deductible include depreciation, amortization, mortgage payments and interest expense. This is not done for preferred stock because preferred dividends are paid with after-tax profitsNet IncomeNet Income is a key line item, not only in the income statement, but in all three core financial statements. While it is arrived at through.
Take the weighted average current yield to maturity of all outstanding debt then multiply it one minus the tax rate and you have the after-tax cost of debt to be used in the WACC formula.
Below is a screenshot of CFI’s WACC Calculator in ExcelWACC CalculatorThis WACC calculator helps you calculate WACC based on capital structure, cost of equity, cost of debt and tax rate. Weighted Average Cost of Capital (WACC) represents a company's blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighte which you can download for free in the form below.
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What is WACC used for?
The Weighted Average Cost of Capital 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. Thus, it is used as a hurdle rate by companies.
A company will commonly use its WACC as a hurdle rateHurdle Rate DefinitionA hurdle rate, which is also known as minimum acceptable rate of return (MARR), is the minimum required rate of return or target rate that investors are expecting to receive on an investment. The rate is determined by assessing the cost of capital, risks involved, current opportunities in business expansion, rates of return for similar investments, and other factors for evaluating mergers and acquisitions (M&AMergers Acquisitions M&A ProcessThis guide takes you through all the steps in the M&A process. Learn how mergers and acquisitions and deals are completed. In this guide, we'll outline the acquisition process from start to finish, the various types of acquirers (strategic vs. financial buys), the importance of synergies, and transaction costs), as well as for financial modeling of internal investments. If an investment opportunity has a lower Internal Rate of Return (IRRInternal Rate of Return (IRR)The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected compound annual rate of return that will be earned on a project or investment.) than its WACC, it should buy back its own shares or pay out a dividend instead of investing in the project.
Nominal vs Real Weighted Average Cost of Capital
NominalNominal DataIn statistics, nominal data (also known as nominal scale) is a type of data that is used to label variables without providing any quantitative value free cash flows (which include inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money).) should be discounted by a nominal WACC and real free cash flows (excluding inflation) should be discounted by a real weighted average cost of capital. Nominal is most common in practice, but it’s important to be aware of the difference.
Below is a video explanation of the weighted average cost of capital and an example of how to calculate it. Watch the video to quickly get a thorough understanding of how it works!
Career Paths
Many professionals and analysts in corporate finance use the weighted average cost of capital in their day-to-day jobs. Some of the main careers that use WACC in their regular financial analysis include:
Investment BankingInvestment Banking Career PathInvestment banking career guide - plan your IB career path. Learn about investment banking salaries, how to get hired, and what to do after a career in IB. The investment banking division (IBD) helps governments, corporations, and institutions raise capital and complete mergers and acquisitions (M&A).
Equity ResearchEquity Research AnalystAn equity research analyst provides research coverage of public companies and distributes that research to clients. We cover analyst salary, job description, industry entry points, and possible career paths.
Corporate DevelopmentCorporate Development Career PathCorporate Development jobs include executing mergers, acquisitions, divestitures & capital raising in-house for a corporation. Corporate
Private EquityPrivate Equity Career ProfilePrivate equity analysts & associates perform similar work as in investment banking. The job includes financial modeling, valuation, long hours & high pay. Private equity (PE) is a common career progression for investment bankers (IB). Analysts in IB often dream of “graduating” to the buy side,
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What is Financial Modeling?What is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model.
Walk Me Through a DCF ModelWalk me through a DCFThe question, walk me Through a DCF analysis is common in investment banking interviews. Learn how to ace the question with CFI's detailed answer guide.
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