The Weighted Average Cost of Capital (WACC) is a crucial financial metric that investors use to determine the value of a company’s combined pool of capital, debt and equity.

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The Weighted Average Cost of Capital explained.

The WACC is the average rate at which a company can expect to finance its business from both equity and debt. This means that it represents the average overall return that both shareholders and debt holders demand to provide the capital the company needs to grow and operate.

When using the Discounted Cash Flow (DCF) modelling technique, the WACC is often used as the discount rate to calculate the net present value of a business. To calculate the WACC, the cost of each capital source, such as debt, preferred shares, and common shares, is weighted by its percentage of total capital before they are added together to create an overall weighted average.

Investors can use the WACC as a tool to determine the required rate of return they need before investing in a company. When investors value a company, they look at the cash flows the company can generate over its lifetime, and discount those future earnings back to their present value. The WACC helps investors by using this average cost as the input to discount the value, and it often reflects the risk associated with the company and the cash flows.

If a company is perceived to have a high level of risk, or the debt is seen as risky, investors will require a higher return, which will cause the WACC to increase. The current theory around stock valuation suggests that the higher the investment risk, the higher the discount rate, which translates into lower valuations.

In the above diagram, we can see how the two components Debt and Equity make up the weighted average cost of capital.

What is the Weighted Average Cost of Capital formula?

Most companies fund their operations using a combination of equity, by issuing shares to the public market, and debt, from loans and bond issuances. The purpose of the weighted average cost of capital is to help determine the cost of each of the capital structure inputs. This is because both have a cost, whether it be interest repayments on loans or dividends paid to shareholders. When valuing a business we must adjust for both sources of capital being used.

• E = Market Value of the Equity component of the business.
• D = Market Value of the Debt component of the business.
• Re = Cost of Equity (Required return to equity/shareholders).
• Rd = Cost of debt (yield to maturity).
• Tc = Corporate Tax Rate.

Below you can see how the Cost of Capital is made up from each of the inputs and what they reflect. Equity is the required return investors seek against risk. The debt component is the amount of debt and the cost to service that debt.

If a company has no debt facilities and is purely funded by equity then the calculation is quite straightforward. If our Cost of Equity is say 10% and that is what investors are seeking as a return guide, then the cost of capital is also 10%. On the opposite side if the company is not issuing shares and using debt only to fund growth and takes out a loan at 3.5% interest. Then the cost of capital is also 3.5%. This is where the weighted average cost of capital comes in, to “blend” these two costs of capital if a company uses both to grow.

Cost of Equity

To determine the Cost of Equity of a firm we use the Capital Asset Pricing Model (CAPM). (For a full break down please read the CAPM article). The equity of a public company is made up of the common shares and preferred shares. You as a shareholder are an “equity” owner.

Using the CAPM helps to determine the cost of equity on a potential investment, which answers two questions: 1) What is the riskiness of this company compared to the market? 2) What return on my capital can I expect for taking on this risk?

The Cost of Equity formula is fairly simple once you understand it.

COE = Rfr+ β x (Rm – Rfr)

• rf = Risk-Free Rate
• β = Beta
• mr = Market Return
• rp = Risk Premium

Cost of Debt

To work out the Cost of Debt is a more straightforward process than the equity component. We take the debt the company carries and divide it by the total capital, multiplied by the cost of debt (interest rate on debt) and finally multiply it by our Tax Shield.

COD = D÷TC x Rd x (1 – Tc)

• D = Market Value of the Debt component of the business.
• TC = Total Capital Equity + Debt.
• Rd = Cost of debt (yield to maturity).
• Tc = Corporate Tax Rate.

Market Value Of Debt

To calculate the cost of debt we need to look at the company’s balance sheet to find the market value. If the company has debt, we can find the book value to use as our market value of debt. This will include all long-term, short-term, and other interest-bearing facilities.

I think it is important to take the average over a 2–3-year period. This is because debt may have increased or decreased and there is interest paid over that timeframe. Using an average rather than a fixed end date helps smoothen out any lumpy and uncommon borrowing patterns.

Cost of Debt

The cost of debt refers to the interest rate that a company pays to service its debt, whether it is interest payments on a loan from a bank or yield to bondholders. By looking at the balance sheet, investors get a good idea of the market value of the debt. Unlike equity, the market value of debt is usually close to the book value and does not deviate to far.

Lending money is typically less risky than investing in equity. Debt payments are predictable and fixed, while equity investors get paid through capital appreciation or dividends and are second in line if the company goes bankrupt.

If a public company has debt, it must report it, and the cost of debt and lending facility interest rates will be included in the reports. As for loan facilities with a BBSR (Bank Bill Swap Rate), this refers to the floating rate that companies pay above the current government interest rates. For example, if a company says it has a loan facility of $100 million at 1.2% BBSR in the US, the rate would be 1.2% on top of the current Federal Funds Rate of 5.31%, making the interest payments 6.51%.

Tax Shield

The reason we use a tax shield is that interest payments are tax deductible. We need to adjust the cost of debt to reflect the company’s tax rate. We cannot ignore the significant tax benefit of borrowing and if missed would create inaccurate valuations. Simply taking the weighted average current maturity rate and multiplying it by one minus the corporate tax rate gives us our after-tax cost of debt.

The corporate tax rate can be found on the Annual report and in the financial statements. Each country has a different corporate tax rate so it is critical to take it from the company reporting and where it is domiciled.

How to use the Weighted Average Cost of Capital?

Let’s now conduct a full walk-through to find the WACC of a company in the below example. To show how each of the inputs is made up, let’s create some base numbers to work off to help us in the calculations.

We’re analyzing a company to find the WACC for our DCF model. The company has the following metrics we can use.

• Total Capitalisation = $2.3 Billion
• Risk-Free Rate = 4.01%
• Beta = 1.38
• Market Premium = 8.02%
• Interest Rate = 3.98%
• Corporate Tax Rate = 25%

WACC Calculation
Capital Structure
Proportion of Equity in Capital Structure	82.33%
Proportion of Debt in Capital Structure	17.67%
Debt-to-Equity Ratio	21.46%
Cost of Equity
Risk-Free Rate	4.01%
Beta	1.38
Risk Premium (Market Premium – RFR)	4.01%
Cost of Equity	9.54%
Market Value of Equity $	$1.89 billion
Cost of Debt
Interest Rate	3.98%
Tax Rate (Tax Shield)	25%
After-Tax Cost of Debt	2.98%
Total Debt $	$407 million
Total Capitalisation $	$2.3 Billion
Weighted Costs
Weighted Debt	0.53%
Weighted Equity	7.85%
Weighted Average Cost of Capital %	8.38%

The best way to interpret the percentage is in terms of money. For example, the WACC of this company is 8.38%, that means that for every dollar of financing (through debt or equity), the company needs to pay $0.0838. 

The WACC can be confusing for new investors or those trying to learn and understand finance. However, once you understand each of the inputs you will be able to not only comprehend it but use it wisely.

The Total Capitalisation is an essential component that determines the percentage of the capital structure allocated to equity and debt. In simple terms, if a company’s total capitalization is $2 million, with $1 million in debt and $1 million in shareholders’ equity, the capital structure would be 50% equity and 50% debt. This percentage is essential because it is used to calculate the Weighted Average Cost of Debt and Equity.

Calculating the Weighted Cost of Equity

To calculate the Weighted Cost of Equity, the inputs from the Capital Asset Pricing Model (CAPM) are used, such as the Risk-Free rate, Beta, and Risk Premium. Once these multiples are combined, we get the Cost of Equity. For instance, if we calculate the Cost of Equity as 9.54%, we need to multiply this by the equity portion of the capital structure. In this example, it is 82.33%. Therefore, the Weighted Average Cost of Equity is 7.85%.

COE = 4.01% + 1.38 x (8.02%- 4.01%) = 9.54%
Weighted average COE = 9.54% x 82.33% = 7.85%

Calculating the Weighted After-Tax Cost of Debt

Similarly, to calculate the Weighted After-Tax Cost of Debt, we first look at the debt component and the interest rate in debt facilities mentioned in the annual report. Suppose the interest rate is 3.98%, and the corporate tax rate is 25%. In that case, the Cost of Debt is calculated by multiplying the interest rate with (1-25%). Hence, the Cost of Debt is 2.98%, and the weighted average cost of debt is 0.53%, which is calculated by multiplying it with the debt portion of the capital structure, which is 17.67%.

COD = 3.98 x (1-25%) = 2.98%
Weighted Average COD = 2.98% x 17.67% = 0.53%

Putting the Weighted Average Cost of Capital together.

Finally, we add the weighted numbers together, i.e., 7.85% and 0.53%, to get the WACC, which is 8.38%. This percentage represents the average cost that investors require to fund the company’s growth. Investors will weigh up the company’s financial strength and risk compared to other investment opportunities to determine whether this return is reasonable.

What are the disadvantages of using WACC?

It’s important to keep in mind that the Weighted Average Cost of Capital (WACC) calculation assumes that there will be no changes in the company’s capital structure. However, this is a rare occurrence, especially if you are modelling a 10-year discounted cash flow (DCF). If a company’s debt or capital structure changes significantly, then the WACC will be dramatically altered.

Another thing to consider is the risk factor. If the discount factor is not high enough to account for changes in the risk profile, then there is little margin for error should a company deviate from its strategy.

Finally, multiples such as beta, risk-free profiles, and interest rates can change quite quickly. For instance, the rapid rise from sub-1% interest rates to over 5% adds a lot of risk to companies that borrowed in a low-interest environment.

It’s essential to understand that the WACC is based on several assumptions, and as logical investors, we must acknowledge that not all assumptions, particularly those based on past data, can be extrapolated with certainty into the future.

The vast majority of private investors do not use the WACC or have heard of it, and they wouldn’t know how to effectively calculate it and then use it. I think all investors need to understand this concept because even if they do not use it, it pushes them to do significant due diligence to come up with the numbers. If an investor has gone to the length to determine the WACC of a potential investment, it shows the level of research they are willing to go through.

In Summary…

The WACC is commonly used as the Discount Factor in DCF modelling work. If, as an equity investor, we demand a return of 8.38%, we can use it as the Discount Factor to bring all future cash flows back to a present value.

To illustrate, just like an individual with a bad credit rating seeking a new unsecured credit loan, a bank charges a higher interest rate to reflect the added risk. The same principle applies in valuation work when it comes to discount rates. The WACC used as the discount rate can be translated into the following:

Higher Discount Rate (WACC) = Higher Risk Investment. The higher discount rate creates a lower valuation, which creates room for error, commonly known as the “Margin of Safety.”

Lower Discount Rate (WACC) = Lower Risk Investment. The lower discount rate creates a higher valuation because there is not much room needed for error. This is often found in good quality growth stocks where paying a “fair price” outweighs trying to find a bargain.

I use the WACC as the discount rate. Most often, my companies have low to no debt, so the Cost of Equity is reflective of the total cost of capital. Personally, I rate the WACC as one of the top 5 key fundamental ratios that investors need to understand. For capital allocators that can raise money at low costs of capital relative to their ROIC may have an advantage over companies that cannot.