How to Calculate WACC

Updated: Mar 5, 2021

When discounting free cash flow to firm in a typical discounted cash flow model the discount rate used is the weighted average cost of capital.

The weighted average cost of capital is a single discount rate that incorporates the cost of debt and cost equity. The reason we use the cost of debt and cost of equity is that when we want to determine the enterprise value of a company we want to find the present value of cash flows to both pieces of the capital structure.

The two types of capital providers are debt capital providers and equity capital providers. Therefore, the enterprise value is the value of the operating business, owned by both debt and equity capital providers.

The cost of each source of capital is not the same. The debt providers have a right to be paid interest and principal as scheduled before the equity capital providers. As a result, the risk to debt providers is less and the appropriate discount rate/cost of debt is lower than the cost of equity (usually).

Debt capital - less risky, gets paid first.

Equity capital - riskier, get paid after creditors.

How do we calculate the WACC?

1) Find the market value of debt and equity

2) Find the after-tax cost of debt and cost of equity

3) Calculate the weighted average of the two different costs of capital

1) Find the market value of debt and equity

The market value of equity is the same as the market capitalization of the company.

The market value of debt is more difficult to determine because fixed income markets are not as liquid or transparent. Alternatively, you can use the book value of debt if it is the best information you have access to.

Assume:

The market value of XYZ corp equity is \$100 million

The market value of XYZ corp debt is \$65 million

2) Find the after-tax cost of debt and cost of equity

The cost of debt is not the interest rate you pay. When interest is paid the interest expense reduces net income which reduces the total taxable income of the business. As a result, the cost of debt is:

Cost of of Debt = Interest Rate * (1 - Tax Rate)

The cost of equity is more difficult to estimate and the topic is somewhat controversial. The most popular method for estimating the cost of equity is the capital asset pricing model (CAPM):

Cost of Equity = Risk-free Rate + Beta*(Equity Risk Premium)

What numbers should you use for the risk-free rate and equity risk premium? Different people have different opinions. Some people use the 10-year treasury for the risk-free rate. The equity risk premium is more difficult to determine but I usually get my estimates from Aswath Damodaran.

Cost of debt = 10% * (1-50%)

Cost of debt = 5%

Cost of Equity = 1% + 1*(5%)

Cost of Equity = 6%

3) Calculate the weighted average cost of capital

In order to calculate a weighted average, we must first calculate the weight of each source of capital.

Weight of equity = Equity market value / (MV Equity + MV Debt)

MV = market value

Weight of Debt = Debt market value / (MV Equity + MV Debt)

MV = market value

Weight of Equity = 100/(100+65)

Weight of Equity = 60.61%

Weight of Debt = 65 / (100+65)

Weight of Debt = 39.39%

Finally, multiple the weights by the respective cost of capital.

WACC = weight of equity * cost of equity + weight of debt * cost of debt

WACC= (.6061 * .06) + (.3939 * .05)

WACC= 5.61%

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