WACC & Discount Rates Tutorial - Understanding Cost of Capital

What is WACC?

WACC (Weighted Average Cost of Capital) is the rate a company is expected to pay to finance its assets, weighted by the proportion of debt and equity in its capital structure.

In DCF valuation, WACC serves as the discount rate that converts future cash flows to present value. It represents the minimum return investors expect for providing capital to the company.

Key Insight: WACC reflects the risk of investing in a specific company. Higher risk companies have higher WACC, which reduces their present value and intrinsic value per share.

The WACC Formula

WACC = (E/V × Re) + (D/V × Rd × (1-Tc))

Where:

E = Market value of equity
D = Market value of debt
V = E + D (total capital)
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate

Component Breakdown:

E/V = Proportion of equity financing
D/V = Proportion of debt financing
(1-Tc) = Tax shield on debt (debt is tax-deductible)

Important: Use market values for debt and equity, not book values. Market values reflect the current cost of capital more accurately.

Cost of Equity: The CAPM Formula

The Cost of Equity (Re) is calculated using the Capital Asset Pricing Model (CAPM):

Re = Rf + β × (Rm - Rf)

Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium

Understanding Each Component:

Risk-Free Rate (Rf)

The return on a theoretical risk-free investment, typically the 10-Year US Treasury yield.

Current typical range: 3.5% - 5.0% (varies with market conditions)
Why 10-Year? Matches the long-term nature of equity investments
Source: Live Treasury yield data from financial markets

Beta (β)

Measures the stock's volatility relative to the overall market (typically the S&P 500).

β = 1.0: Stock moves exactly with the market
β > 1.0: Stock is more volatile (higher risk) - Tech stocks often have β = 1.2-1.5
β < 1.0: Stock is less volatile (lower risk) - Utilities often have β = 0.6-0.8
β = 0: Stock is uncorrelated with market (rare)

Example: If Tesla has β = 2.0 and the market rises 10%, Tesla's stock would be expected to rise 20%. If the market falls 10%, Tesla would fall 20%.

Equity Risk Premium (Rm - Rf)

The extra return investors demand for investing in stocks versus risk-free bonds.

Historical average: 6-8% over long periods
Current estimates: 4-6% based on market conditions
Interpretation: Higher premiums indicate investors perceive more market risk

CAPM Example Calculation:

Given:

Risk-Free Rate (Rf) = 4.5%
Beta (β) = 1.3
Equity Risk Premium = 6.0%

Calculation:

Re = 4.5% + 1.3 × 6.0%

Re = 4.5% + 7.8%

Cost of Equity = 12.3%

Cost of Debt (Rd)

The cost of debt is the effective interest rate a company pays on its borrowings.

Calculation Methods:

Method 1: From Financial Statements

Formula:

Rd = Interest Expense ÷ Total Debt

Most accurate as it reflects the company's actual borrowing costs

Method 2: Bond Yield to Maturity

Formula:

Rd = Current YTM on company bonds

Use for companies with publicly traded bonds

Tax Shield Benefit

Interest payments are tax-deductible, reducing the effective cost of debt:

After-tax cost of debt = Rd × (1 - Tax Rate)

Example: If Rd = 5% and Tax Rate = 25%, after-tax cost = 5% × (1 - 0.25) = 3.75%

Capital Structure Weights (E/V and D/V)

The weights represent the proportion of equity and debt in the company's capital structure.

How to Calculate:

Step 1: Determine market value of equity (E)

E = Share Price × Shares Outstanding

Step 2: Determine market value of debt (D)

D = Total Debt (use book value if market value unavailable)

Step 3: Calculate total value (V)

V = E + D

Step 4: Calculate weights

E/V = Equity Weight

D/V = Debt Weight

Example Calculation:

Company ABC:

Market value of equity (E) = $800 million
Market value of debt (D) = $200 million
Total value (V) = $1,000 million

Equity Weight (E/V) = $800M / $1,000M = 80%

Debt Weight (D/V) = $200M / $1,000M = 20%

Complete WACC Calculation Example

Given Information:

Capital Structure:

Market value of equity (E) = $800M
Market value of debt (D) = $200M
Total value (V) = $1,000M

Cost Components:

Risk-free rate = 4.5%
Beta = 1.3
Equity risk premium = 6.0%
Cost of debt = 5.0%
Tax rate = 25%

Step-by-Step Calculation:

Step 1: Calculate Cost of Equity (Re) using CAPM

Re = 4.5% + 1.3 × 6.0%

Re = 12.3%

Step 2: Calculate After-Tax Cost of Debt

Rd(after-tax) = 5.0% × (1 - 0.25)

Rd(after-tax) = 3.75%

Step 3: Calculate Weights

E/V = $800M / $1,000M = 80%

D/V = $200M / $1,000M = 20%

Step 4: Calculate WACC

WACC = (0.80 × 12.3%) + (0.20 × 3.75%)

WACC = 9.84% + 0.75%

WACC = 10.59%

Common WACC Calculation Mistakes

Using Book Values Instead of Market Values

Always use market values for equity (share price × shares) and debt. Book values are historical and don't reflect current capital costs.

Forgetting the Tax Shield

Always multiply cost of debt by (1 - Tax Rate). Failing to account for the tax deductibility of interest overstates WACC.

Using Arbitrary Discount Rates

Avoid using generic rates like "10%" or "12%". Calculate company-specific WACC to reflect actual risk and capital structure.

Inconsistent Risk-Free Rate

Match the risk-free rate term to your projection period. Use 10-Year Treasury for typical DCF models with 5-10 year projections.

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WACC & Discount Rates