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WACC

 

WACC (Weighted Average Capital Cost) shows cost of capital when capital is consisted of both equity and debt capital. So WACC simply calculates the weighted average between equity cost and debt cost.

 

WACC is used in many financial calculations as well in DCF firm’s valuation as discount rate. Normally WACC is between 7% and 10%, however, for some case may broke these boundaries. The higher WACC shows higher risk and return. 

 

You may calculate WACC of the firm using attached form of DCF valuation sample

 

WACC formula for calculation


WACC = Equity proportion * Cost of equity + Debt proportion * Cost of debt * (1-Tax)


Equity proportion = market value of equity capital / total market value of capital

 

Debt proportion = market value of debt capital / total market value of capital

 

Tax = Corporate tax rate (some analysts are using nominal rate, some effective tax rate)

 

* This formula is simplified and do not includes the calculation of cost of equity and cost of debt. However to calculate WACC by yourself correctly, you need to be real finance expert with many years of experience in this field. If you want to try calculate WACC it would be advisable to use the form that is linked above.   

 
 
Main parts in WACC:
  • Equity and debt proportions determine which cost (debt or equity) is more important to the weighted result. Some financial analysts are still using book values of the debt and equity (from the balance sheet) but using the market value is more correct practice. There may be many methods to determine market value. For example, if company is listed on stock exchange, then market value of equity will be equal to the market capitalization. 
  • Cost of equity should represent the rate of return that is required by company’s shareholders. But that is theoretically because shareholders may wish to get return that is not possible on the market, and to use such ratio in practice required return has to meet market conditions. More unbiased determination of cost of equity can be possible using CAPM.  
  • Cost of debt is interest rate that is paid for company’s financial liabilities. Every company that has financial liabilities (if company does not have these, then cost of debt is not important) has to pay some interests for it. Cost of debt should be the interest rate that would be paid by the company for its debts during calculation (according to the latest market conditions).
  • Tax rate is a rate for corporate income tax and is used to get after-tax rate. Cost of debt is reduced by corporate income tax rate because interest expenses reduce income tax paid by the companies. 
Maybe WACC formula looks simple, but in reality WACC is very sensitive to the value of DCF and little mistake in WACC calculation may have dramatic impact to the result. There are many nuances that are important for WACC and it is not very surprising that different analysts are getting different WACC for the same company.






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