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cost of-capitalintermediate20 min
WACC Calculation Guide
How to calculate WACC from scratch: finding cost of equity, cost of debt, and capital weights.
What You'll Learn
- ✓Estimate cost of equity using CAPM
- ✓Find after-tax cost of debt
- ✓Combine using market-value weights
1. Find Cost of Equity
Use CAPM: Re = Rf + beta × (Rm - Rf). Get Rf from Treasury yields, beta from data providers, and MRP from your textbook.
Key Points
- •Match Rf maturity to investment horizon
- •Use regression beta or published beta
- •MRP is typically 5-7%
2. Find Cost of Debt
Use YTM on existing bonds or the interest rate on recent borrowings. Tax-adjust: Rd × (1-T).
Key Points
- •YTM is better than coupon rate
- •Always tax-adjust for WACC
- •Multiple debt issues: use weighted average
3. Determine Weights
Use market values of equity and debt. Market cap for equity; for debt, use market price × face value outstanding.
Key Points
- •Market weights, not book weights
- •Equity = share price × shares outstanding
- •If market debt data unavailable, book is a fallback
4. Combine into WACC
WACC = (E/V) × Re + (D/V) × Rd × (1-T). Include preferred stock if applicable.
Key Points
- •E + D = V (total firm value)
- •Preferred stock gets its own term without tax adjustment
- •WACC should be between Rd(1-T) and Re
Key Takeaways
- ★WACC typically falls between 8-12% for US companies
- ★Higher leverage first decreases then increases WACC
- ★Use project-specific WACC if risk differs from firm average
Practice Questions
1. Equity beta is 1.2, Rf = 3%, MRP = 6%. What is Re?
Re = 3% + 1.2 × 6% = 10.2%.
2. Firm borrows at 8%, tax rate 25%. After-tax cost of debt?
8% × 0.75 = 6.0%.
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FAQs
Common questions about this topic
Only for projects with similar risk to the firm overall. Adjust the discount rate for riskier or safer projects.
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