About the WACC Calculator
The weighted average cost of capital is the return a company has to earn just to keep both its lenders and its shareholders content. The formula is WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc), where E and D are the market values of equity and debt, V is their sum, Re and Rd are the costs of each, and Tc is the corporate tax rate. It becomes the discount rate in most valuation models and the hurdle rate for investment approvals.
Debt looks cheap here for two reasons. Lenders rank ahead of shareholders and take less risk, so they demand less, and interest is deductible against tax, which is why the cost of debt is multiplied by one minus the tax rate. This page shows that tax shield as its own line so you can see how many basis points it is worth. Cost of equity normally comes from the capital asset pricing model, adding a beta adjusted market premium to a risk free rate.
Use market values rather than book values for the weights, because a company funded by shares trading at three times book has a very different mix from what the balance sheet suggests. Also remember that WACC applies to the company as a whole and assumes the funding mix stays put. A project riskier than the existing business needs its own higher rate, which is why divisional hurdle rates exist. Feed the answer into the Economic Value Added Calculator to charge the business for the capital it uses.
How to use
- Enter the market value of equity, which is the market capitalisation.
- Enter the market value of debt, using book value if the debt is mostly bank borrowing.
- Set the cost of equity and the pre tax cost of debt as percentages.
- Add the corporate tax rate and read the WACC along with the tax shield line.
Common questions
- How do I find the cost of equity?
- Most analysts use the capital asset pricing model: risk free rate plus beta multiplied by the equity risk premium.
- Why is the cost of debt reduced by tax?
- Interest is tax deductible, so a company paying seven percent at a twenty five percent tax rate really bears 5.25 percent.
- Should weights use book or market values?
- Market values. Book equity reflects historical accounting and can be far below what investors currently price the shares at.
- Can WACC be used for every project?
- Only for projects with the same risk as the existing business. Riskier ventures need a higher discount rate of their own.