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WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight and then adding the products together. In the above formula, E/V represents the proportion of equity-based financing, while D/V represents the proportion of debt-based financing.
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Cost of equity (Re) can be a bit tricky to calculate because share capital does not technically have an explicit value. When companies reimburse bondholders, the amount they pay has a predetermined interest rate. On the other hand, equity has no concrete price that the company must pay. As a result, companies have to estimate cost of equity—in other words, the rate of return that investors demand based on the expected volatility of the stock.
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Companies typically use the Capital Asset Pricing Model (CAPM) to arrive at the cost of equity (in CAPM, it’s called the expected return of investment). Again, this is not an exact calculation because firms have to lean on historical data, which can never accurately predict future growth.
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Determining cost of debt (Rd), on the other hand, is a more
straightforward process. This is often done by averaging the yield to maturity for a company’s outstanding debt. This method is easier if you’re looking at a publicly traded company that has to report its debt obligations.
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Businesses are able to deduct interest expenses from their taxes. Because of this, the net cost of a company’s debt is the amount of interest it is paying minus the amount it has saved in taxes. This is why Rd (1 – the corporate tax rate) is used to calculate the after-tax cost of debt.
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Weighted Average Cost of Capital (WACC) Explained with Formula and Example
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