ModeldrillWACC
WACC = E/(D+E) x cost of equity + D/(D+E) x cost of debt x (1 - tax rate), using market values for E and D. Cost of equity usually comes from CAPM: risk-free rate + beta x equity risk premium. WACC is the discount rate for unlevered free cash flows.
Syntax
WACC = E/V x Re + D/V x Rd x (1 - t), where V = D + E and Re = Rf + beta x ERP| Part | What it is |
|---|---|
E, D | Market value of equity and of debt |
Re | Cost of equity, usually from CAPM |
Rd | Pre-tax cost of debt, the yield the company would pay on new borrowing |
t | Marginal tax rate, because interest is tax deductible |
Examples
E = 600, D = 400, Re = 12%, Rd = 6%, t = 25%
=600/1000 * 12% + 400/1000 * 6% * (1 - 25%)Result: 9.0%
7.2% from equity plus 1.8% from after-tax debt.
Cost of equity by CAPM: Rf 3%, beta 1.2, ERP 5.5%
=3% + 1.2 * 5.5%Result: 9.6%
E = 800, D = 200, Re = 10%, Rd = 5%, t = 21%
=0.8 * 10% + 0.2 * 5% * (1 - 21%)Result: 8.79%
Common mistakes
- Using book value of equity: WACC weights are market values, so use market capitalization for E, and market or book debt if debt trades near par.
- Forgetting the tax shield on debt: multiply the cost of debt by (1 - tax rate), not the cost of equity.
- Using the coupon on old debt as Rd: use the current yield on the company's debt or on comparable credits.
Practice WACC
These drills check your answer on live data, free, no account needed.
- Discount factors and present valuesFill the discount factor for each year (row 6: 1 divided by (1 + rate) to the power of the year), the present value of each cash flow (row 7) and the total present value in B8.
- Unlevered free cash flowFill NOPAT (row 6: EBIT after tax at the rate in B2) and unlevered free cash flow (row 10: NOPAT plus depreciation, less capital spending, less the increase in working capital).
Questions
What is a typical WACC?
For large, stable listed companies roughly 7% to 10%; higher for small, cyclical or emerging-market businesses. It depends on rates, beta and leverage, so compute it rather than assume.
Does more debt lower WACC?
At first, because after-tax debt is cheaper than equity. Beyond a point, higher leverage raises both Rd and beta, and WACC rises again.
Related
- DCF model stepsThe six steps of a DCF: forecast unlevered free cash flow, set WACC, compute terminal value, discount it all, bridge to equity value and divide by shares.
- Unlevered free cash flowUnlevered free cash flow = EBIT x (1 - tax rate) + D&A - capex - increase in net working capital. Examples from EBIT and from EBITDA, plus the sign rules.
- Discount factorA discount factor converts a future cash flow into present value: DF = 1 / (1 + r)^t. Worked examples, the Excel formula with absolute references, mid-year.
- Terminal valueTerminal value captures all cash flows after the forecast period. Perpetuity growth and exit multiple formulas with examples, and how to discount it right.