A company is financed by debt and equity. Each group of investors demands a return. The weighted average cost of capital (WACC) is the blended return the firm must earn on its assets to satisfy both.
E is the market value of equity, D the market value of debt, and V = E + D. If the firm has preferred shares, add a third term at the preferred dividend yield.
Equity is worth 600 and debt 400. Cost of equity is 10%, pre-tax cost of debt 6%, tax rate 25%.
Lenders are paid before shareholders and hold a fixed claim, so they accept a lower return, and interest is tax-deductible. But adding debt raises the risk and required return of the remaining equity, so WACC does not fall in a straight line (Module 7).
WACC is the discount rate for free cash flows that belong to all investors (unlevered free cash flow). It is the hurdle rate for projects with the same risk as the firm's existing business. A riskier project needs a higher rate and a safer one a lower rate; using one company-wide rate makes a firm over-invest in risky divisions and under-invest in safe ones. Multi-division firms estimate divisional rates from pure-play peers.
EVA = after-tax operating profit minus (WACC x invested capital). For Maple Outfitters: 97.5 minus 7.8% x 760 = 97.5 minus 59.3 = 38.2. Positive EVA means the firm earns more than its capital costs.
Book-value weights; coupon rate instead of current yield; forgetting the tax adjustment on debt; a cost of equity below the cost of debt; mixing currencies (for example a US dollar risk-free rate for Canadian dollar cash flows); and false precision. WACC is an estimate, usually good to within about one percentage point, so always show a sensitivity range.
A Canadian company has 200 million shares at $25 and bonds with a face value of 2,000 trading at 98% of par. The 10-year Government of Canada yield is 4.0%, the company's beta is 1.1, the ERP is 5%, its bonds yield 5.8% and the combined federal and provincial tax rate is 26.5%.
| Input | Value |
|---|---|
| Equity (E) | 200 million x $25 = 5,000 |
| Debt (D) | 2,000 x 0.98 = 1,960 |
| E / V and D / V | 71.8% and 28.2% |
| Cost of equity | 4.0% + 1.1 x 5% = 9.5% |
| After-tax cost of debt | 5.8% x (1 minus 0.265) = 4.26% |
| WACC | 0.718 x 9.5% + 0.282 x 4.26% = 8.0% |
With the ERP at 4% the cost of equity is 8.4% and WACC 7.2%; at 6% they are 10.6% and 8.8%. A one-point change in the ERP moves WACC by about 0.8 points here, because equity is most of the capital.
A business producing a steady free cash flow of 100 a year forever is worth 100 / 8% = 1,250 at an 8% WACC and 100 / 9% = 1,111 at 9%, a fall of 11% from one percentage point. With growth in the formula (Module 2), the effect is larger still.
Use the capital structure the company is expected to maintain over the life of the cash flows. If a company has just borrowed heavily for an acquisition and plans to pay the debt down, its current weights overstate the long-run debt share. Rating agency targets and management's stated leverage policy help.
Preferred dividends are not tax-deductible, so preferred capital enters WACC at its full yield. A company with 500 of preferred shares yielding 6% adds that layer at 6%, not 6% x (1 minus tax rate). Convertible bonds are part debt and part equity; analysts often split them.
Estimate an unlevered beta from pure-play peers for each division, relever at the division's target leverage, and compute a separate rate. The group WACC is the value-weighted average of the divisional rates, which is a useful check.
Estimate the WACC of a real company: market capitalization, total debt from the balance sheet, a beta, the current 10-year government yield, a 5% ERP, the company's bond yield or an estimated spread, and the statutory tax rate. Show the result at ERP of 4%, 5% and 6%.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.