Calculating the Weighted
Average Cost of Capital
(WACC)
In this chapter we discuss the calculation of the firm’s weighted average cost of capital (WACC). The
WACC has two important uses in finance:
1) When used as the discount rate for a firm’s anticipated free cash flows (FCFs), the WACC gives
the enterprise value of the firm. At this point, it suffices to say that the FCF is the cash flow
generated by the firm’s core business activities.
2) The WACC is also the appropriate risk-adjusted discount rate for firm projects whose riskiness is
similar to the average riskiness of the firm’s cash flows. When used in this context, the WACC is
often referred to as the firm’s “hurdle rate.” The WACC is a weighted average of the firm’s cost of
equity rE and its cost of debt rD, with the weights created by the market values of the firm’s
equity (E) and debt (D):
A terminological note : “Cost of capital” is a synonym for the “appropriate discount rate” to be
applied to a series of cash flows.
In finance “appropriate” is most often a synonym for “risk-adjusted.” Hence another name for the
cost of capital is the “risk-adjusted discount rate” (RADR).
This chapter discusses the computation of the five components of the WACC—the market value of
the firm ’ s equity and debt E and D , the firm ’ s tax rate T C , the firm ’ s cost of debt r D , and the
cost of equity r E .
1.Computing the Value of the Firm’s Equity, E
Of all the computations related to the WACC, computing the value of the firm’s equity is the easiest:
As long as the company is publicly listed, take E to be the product of the number of shares
outstanding times the current value per share.
2. Computing the Value of the Firm’s Debt, D
We compute the value of the firm’s debt by the market value of its financial debt minus the market
value of its excess financial assets. A common approximation for this number is to take the balance
sheet value of the firm’s debt minus the value of the firm’s cash balances and minus the value of its
marketable securities.
3. Computing the Firm’s Tax Rate, TC
In the WACC formula, TC should measure the firm’s marginal tax rate, but it is common to measure
it by computing the firm’s reported tax rate.
Usually this should cause no problems, as the following example shows for Apple (AAPL):
The tax rate for Apple is somewhat stable. In our WACC computation we would most likely use the
current tax rate or the average over the past several years or the expected tax rate, if we have
specific knowledge about it. Companies like Apple are very good at placing their income in
comfortable tax venues, and it appears that a reasonable estimate for the tax rate is somewhere
between 16% and 18%
4. Computing the Firm’s Cost of Debt, rD
We now turn to calculating the cost of debt rD. In principle, rD is the marginal cost to the firm
(before corporate taxes) of borrowing an additional dollar.
There are at least three ways of calculating the firm’s cost of debt. We will state them briefly
below and then go on to illustrate the application of one of the methods. Although the
methods may not be theoretically perfect, they are often used in practice.
• As a practical matter, the cost of debt can be approximated by taking the average cost of
the firm’s existing debt. The problem with this method is that it runs the danger of confusing
the past costs with the future anticipated cost of debt that we actually want to measure.
We can use the yield of similar-risk, newly issued corporate securities. If a company is rated A
and has mostly medium-term debt, then we can use the average yield on medium-term, A-rated
debt as the firm’s cost of debt. Note that this method is somewhat problematic because the yield
on a bond is its promised return, whereas the cost of debt is the expected return on a firm’s debt.
Since there is usually a risk of default, the promised return is generally higher than the expected
return. Nevertheless, despite the problematic, this method is often a good compromise,
specifically for relatively safe debt.
• We can use a model that estimates the cost of debt from data about the firm’s bond prices,
the estimated probabilities of default, and the estimated payoffs to bondholders in case of
default. This method requires a lot of work and is mathematically nontrivial. For cost of capital
calculations, it would be used in practice only if the firm we are analyzing has significant amounts
of risky debt.
The first two methods above are relatively easy to apply, and in many cases the problems or errors
that are encountered in these methods are not critical. As a matter of theory, however, both
methods fail to make proper risk adjustments for the cost of the firm’s debt.
The third method, which involves computing the expected return on a firm’s debt, is more in line
with standard financial theory, but it is also more difficult to apply. It may not, therefore, be worth
the effort.
In the remainder of this section, we apply the first of these methods to calculate the cost of debt
for Caterpillar.
END
