![]() ![]() Using some simple multiplication, I'll run the calculation, and find that my WACC is 5.625%. And I'm going to assume here that the cost of equity is 8%. So half of my WACC will be based off the cost of debt and the other half will be based off the cost of equity. I'm going to assume a debt equity ratio of 1:1. #AFPONLINE COST OF CAPITAL PLUS#The next part of our equation is debt divided by the market value of debt plus equity. And this is why we apply the one minus Tc value to the WACC formula. and 35%.īecause interest payments on debt reduce the amount of tax the company pays, the effective cost of debt is lower than 5%. I'm also going assume that the corporation tax rate is based on the U.S. And for this fictional company, I'm going to assume that there's a cost of debt, or an interest rate payment, of 5%. Let's now apply some values to this formula so you can see it in action for a fictional company. And then, the second portion of the equation, looks after the cost of equity, which is r e, and multiply it by the market value of the equity, divided by the market value of the debt, plus the equity. And so, this portion of the equation looks after the cost of debt. This is then multiplied by a fraction, which is the market value of the debt, divided by the market value of the debt, plus the market value of the equity. So the weighted average cost of capital is equal to the cost of debt, multiplied by one minus the tax rate. There's quite a few variables, so what I'll also include is my definition for each of these variables. So let's take a look at the formula for calculating the weighted average cost of capital. And the weighted average cost of capital simply calculates the weighted average for both the debt and equity investors in the company. ![]() Needless to say, the required rate of return for a debt holder is different to that of an equity holder. Form an investors perspective, the cost of capital is the required rate of return by those investing in the business. While analysts disagree often on what the correct discount rate for a company is, at least they do use the same concept called the Weighted Average Cost of Capital. Analysts often disagree how the discount rate is calculated and it's important, when valuing a business, to stand over your discount rate assumptions. Which will have different discount rates. For businesses we have the added complication of debt and equity. But what should this discount rate be? This is one of the most contentious questions in finance and it's important because the discount rate you use can dramatically change your valuation of a company. We calculate the future cashlfows for the company, and then discount these cashlfows back to a present value. The same principle applies when valuing companies. Essentially, to calculate the value of an asset, we forecast future cashflows, and then discount these cashflows by the discount rate before adding the discounted cashlfows together to calculate our net present value. In previous courses, you may have heard me explain a concept called the time value of money and discounting future cashflows. Adding the two components of the formula produces the WACC, or the discount rate that can be used to value the company based on its future cashflows. ![]() The cost of equity is weighted by the proportion of debt and equity in the company that is held as equity. The second part of the formula deals with the required rate of return for equity holders. The fraction expression represents the weighting, and its size represents the proportion of debt and equity in the company that is held as debt. ![]() As a result, the effective cost of debt is reduced by an amount that depends on the corporate tax rate. Interest payments on debt reduce the amount of tax the company pays. The first part of the formula deals with the required rate of return for debt holders. \(V\) is the market value of debt and equity in the company, i.e.\(E\) is the market value of equity in the company.\(D\) is the market value of debt in the company.\(r_E\) is the required rate of return for equity holders, or the cost of equity.\(r_D\) is the required rate of return for debt holders, or the cost of debt.Debt holders and equity holders have different costs of capital, so the WACC provides a weighted average of these two figures. The Weighted Average Cost of Capital, or WACC, is a method for calculating the required rate of return, or the cost of capital, for people investing in a business. ![]()
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