## What is WACC?

The **Weighted Average Cost of Capital (WACC)** is one of the key inputs in discounted cash flow (DCF) analysis and is frequently the topic of technical investment banking interviews.

The WACC is the rate at which a company’s future cash flows need to be discounted to arrive at a present value for the business. It reflects the perceived riskiness of the cash flows.

Put simply, if the value of a company equals the present value of its future cash flows, WACC is the rate we use to discount those future cash flows to the present.

Table of Contents

- WACC Formula
- Cost of Capital Basics
- Risk-Free Rate
- Capital Structure
- Capital Structure — Debt and Equity Mix
- Cost of Debt
- Tax Shield
- Marginal vs Effective Tax Rate
- Tax Rate in the WACC Calculation
- Cost of Equity
- Capital Asset Pricing Model (CAPM)
- Cost of Equity Formula
- Risk-Free Rate
- Equity Risk Premium (ERP)
- Calculating Beta
- Calculating Raw (Historical) Beta
- Adjusted Beta
- Industry Beta
- Unlevered to Levered Beta Formula
- Unlevering Peer Group Beta
- Relevering Beta
- WACC in the Real World

## WACC Formula

Below we present the WACC formula. To understand the intuition behind this formula and how to arrive at these calculations, read on.

Where:

- Debt = market value of debt
- Equity = market value of equity
- r
_{debt }= cost of debt - r
_{equity }= cost of equity

## Cost of Capital Basics

Before getting into the specifics of calculating WACC, let’s understand the basics of why we need to discount future cash flows in the first place. We’ll start with a simple example:

Suppose I promise to give you $1,000 next year in exchange for money upfront. What’s the most you would be willing to pay me for that today? Would you be willing to pay me $500? What about $800? Your decision depends on the risk you perceive of receiving the $1,000 cash flow next year.

**Low risk = low return:**If you feel there is little to no risk of not getting paid, you would quantify your opportunity cost as low. You’d be willing to pay more, and thus receive a lower return.**High risk = high return:**If you feel the chance of actually collecting the $1,000 is very low, you may not be willing to part with much money today. In other words, you’d discount at a high rate.

It should be easy from this example to see how **higher perceived risk correlates to a higher required return** and vice versa. The challenge is how to quantify the risk. The WACC formula is simply a method that attempts to do that.

We can also think of this as a **cost of capital** from the perspective of the entity raising the capital. (In our simple example, that entity is me, but in practice it would be a company.) If I promise you $1,000 next year in exchange for money now, the higher the risk *you* perceive equates to a higher cost of capital *for me*.

Here’s an easy way to see this: Imagine you decide there’s a high risk of me not paying you $1000 in the future, so you’re only willing to give me $500 today. For me, that amounts to a 100% interest rate ($500 principal return + $500 in interest).

It should be clear by now that raising capital (both debt and equity) comes with a cost to the company raising the capital: The **cost of debt** is the interest the company must pay. The **cost of equity** is dilution of ownership.

While our simple example resembles debt (with a fixed and clear repayment), the same concept applies to equity. The equity investor will require a higher return (via dividends or via a lower valuation), which leads to a higher cost of equity capital to the company because they have to pay the higher dividends or accept a lower valuation, which means higher dilution of existing shareholders.

It should be clear by now that raising capital (both debt and equity) comes with a cost to the company raising the capital: The **cost of debt** is the interest the company must pay. The **cost of equity** is dilution of ownership. From the lender and equity investor perspective, the higher the perceived risks, the higher the returns they will expect, and drive the cost of capital up. It’s two sides of the same coin.

### Risk-Free Rate

Let’s get back to our simplified example, in which I promise to give you a $1,000 next year, and you must decide how much to give me today. Even if you perceive no risk, you will most likely still give me less than $1,000 simply because you prefer money in hand. The rate you will charge, even if you estimated no risk, is called the **risk-free rate**. When investors purchase U.S. treasuries, it’s essentially risk free — the government can print money, so the risk of default is zero (or close to it). The return on risk-free securities is currently around 2.5%. Because you can invest in risk-free U.S. treasuries at 2.5%, you would be crazy to give me any more than $1,000/1.025 = $975.61.

As we’ll see, it’s often helpful to think of cost of debt and cost of equity as starting from a baseline of the risk-free rate + a premium above the risk-free rate that reflects the risks of the investment.

How to compute the total amount of debt in the company’s capital structure that will meet WACCof 10%? GIven: Total equity = $2,000,000 Before tax of debt is 7% Cost of equity is 16% Corporate income tax rate is 17% I calculate cost of debt is 5.81%, but I do… Read more »

Can you help in this question below, WACC is calculated to me as 12.5892.. Is it correct The management of “BK” company is evaluating an investment project that will give a return of 15%. The project requires 10 million LE as a total investments that will be financed as follows:… Read more »

For the calculation of the debt, usually in the balance sheet we find long-term debt and short-term debt. Which is correct? to consider Total debt, (short term and long term debt), or to take only long term debt for the WACC calculation?

If a company that I’m analyzing has a large NOL balance, should I used 0% as the tax rate in my WACC calculation?

Yes

Can you please explain in simple words on an intuitive level the painful question, when a company issues debt, then EV does not change if this money does not go to operating activities , but for example, having issued a debt today, then the next day, why is the company… Read more »

if a company generates revenue from multiple countries (e.g. Italy, US and Brazil), which country’s inflation differential should we use?

Hi, I’m very curious to what formula was used to calculate the “delev B” for Apple beta, which is 1.15. I‘m assuming you are using the unlevered formula and if you are could you explain by detail, by plugging in values into the formula, how you got to a beta… Read more »

how to find WACC of a company if a company has $720 million in common stock outstanding. Its cost of equity is 12%. Moreover, it has $360 million in 6% coupon rate bonds outstanding. The bond is currently sold at par. There are no taxes in the country in which… Read more »