WACC is often difficult to calculate, mostly because the calculation is based on many assumptions, even when the formula seems pretty straightforward. WACC can vary from people to people, depending on who is doing the calculations. Therefore, being able to understand WACC conceptually and have a good grasp of what assumptions go into the math are very important.
1. What is WACC for?
Companies need financing. They can do so in two ways: through debt or equity. They can issue corporate bonds; they can list their stocks on a stock exchange; or they can take out loans from a commercial bank. All of these methods of financing come at a cost for the company. This is known as the cost of capital.
Because there are a lot of capital costs associated with each type of financing, to represent all the costs with one single number, companies need to weight each category of capital proportionately and sum them up. The final result is known as the weighted average cost of capital. WACC measures the cost of financing through equity or the weight of debt for, say, a company’s expansions, using the current level of debt and equity structure.
Some applications of WACC include:
- On DCF model to value a company’s implied enterprise and equity value
- By management team to decide whether to finance the company through debt or equity
- Assessing a firm’s potential for profitability
- For stakeholders to estimate how much returns they can expect
The Equity Weight (E)
For public companies, you can simply derive the equity weight by multiplying the diluted shares outstanding by the market share price. For private companies, calculating the equity value is more difficult. In this case, you can use an indirect approach by using comparable company analysis to estimate the equity value.
The Debt Weight (D)
To determine the debt value, you can use the book value of debt from the company’s latest balance sheet as an approximation for the market value of debt. The debt value is often not that deviant from the market value as a rule of thumb, so you can trust the number on the balance sheet as a good approximation.
Corporate Effective Tax Rate (Tc)
In calculating the debt weight, we use the after-tax adjustment weight because the cost of debt will account for a smaller weight after tax adjustment. The effective tax rate used for WACC calculation might differ from the effective tax you see on the company’s 10-K depending on their operations and how they report tax.
In the United States for example, there are two ways of calculating tax rate: effective or statutory tax rate.
- Effective tax rate = GAAP taxes / GAAP pretax income
- Statutory tax rate = calculated using the progressive tax system.
The difference might occur depending on where the companies operate and how they report tax. In case the two rates are wildly different, stick to these rules of thumb:
- If the current effective tax rate is significantly lower than the statutory tax rate and the tax rate is likely to rise, slowly increase the effective tax rate from stage 1 until it reaches the statutory rate in the terminal year.
- If the difference is systemic and likely to endure, use the lower tax rate.
Intuition for cost of debt and cost of equity
Before we move into unpacking the concepts of the cost of debt and equity, it is helpful to stop here to understand the general intuition behind how the cost of capital is quantified.
The cost of capital in general increases with risks. The higher the risks, the more you have to pay to the party promising to give you the money. The cost of capital can therefore be simply understood to be the sum of the risk-free rate and a risk premium that reflects the level of risk of that investment.
The risk-free rate can be estimated by the risk-free U.S. treasuries returns rate. For companies in Asia, you might want to use the returns rate for the Japanese government’s treasuries bonds; for companies in Europe, use Germany’s government bonds as estimations.
The Cost of Debt
Quantifying the cost of debt financing is pretty simple because it is just the interest rate associated with the debt-financing instrument. For example, if the company takes out a 2-million loan from a commercial bank at a 7.5% interest rate per year. The cost of debt in this example is conceptually 7.5%.
However, this nominal cost of debt might not hold true for the company in perpetuity. To calculate the cost of debt in real life, use one of these three rules:
1. For companies with public debts (bonds): the cost of debt is the yield to maturity (YTM) on the company’s long-term debt. This information can be found on Bloomberg terminal.
2. For companies without any public debts but have a credit rating: the cost of debt is the sum of the default spread associated with that credit rating (risk premium) plus the risk-free rate.
3. For companies without any ratings: use the interest rate on its latest long-term debt as approximation.
The Cost of Equity
The cost of equity is the cost a company needs to pay to maintain a share price that is satisfactory to investors. The cost of equity is more challenging to put a number on it as share capital carries no explicit cost. Equity does not have a concrete price tag attached to it. However, several models exist to estimate the cost of equity.
In this article, we will focus on how to use the Capital Asset Pricing Model (CAPM) to derive the equity cost. Under this model, the cost of equity is calculated using this formula:
Equity risk premium (ERP) is the risk premium of investing in equities over risk-free capital. ERP is usually around 4-6%. Damodaran is a website that provides the most updated ERPs for free.
(beta) is the company’s sensitivity to systematic risk in the market. For example, for a company with a beta of 2, the returns of its equity will rise or fall twice as fast as the market does. If the S&P were to increase by 1.5%, the company’s stock value would be expected to increase or drop by 3%.
In real life, to calculate the beta for a specific company, it is often fundamentally risky to use historical precedents, as the results might be skewed by factors other than the market. This is when the industry-specific beta comes in, often derived from a comparable company analysis.
3. How to calculate WACC for a public company?
After understanding the concepts behind WACC, it is time to put what we learn in practice. In this section, we will build an Excel model to estimate WACC for Walmart. This is pretty much a standard guideline for any public companies. However, remember that each company is different, and the model can vary depending on the amount of information we have as an analyst.
Step 1: Prepare hard-coded inputs
Hard-coded inputs for the WACC formula include the risk-free rate, effective tax rate, and equity risk premium. This information can be easily found online using websites we provided above.
Step 2: Estimate the capital weights
Step 3: Estimate Cost of Debt
For the sake of simplicity, in this case example, we will use Walmart’s latest long-term interest rate as an approximation. To access this information, we will use Capital IQ’s database. Here is a screenshot of Walmart’s list of debt securities:
Source: Capital IQ
For the debt maturing on December 15th 2020, the rate of return for creditors (the cost of debt for Walmart as debtors) is 1.9%.
Step 4: Calculate Beta
You have two options for beta:
- You can take the historical beta based on its stock performance and relevant indexes.
- You can come up with a new beta based on a set of public companies. You can look up comparable public companies’ betas, unlever each one, take the median of the set and then lever that median based on the company’s capital structure.
We will illustrate the steps of calculation for the latter option. First of all, we will look up betas for Walmart’s comparable companies using Capital IQ.
First, you will want to unlever each company’s beta based on their total debt, equity and effective tax rate based on this formula and find the median.
Unlevered Beta=Levered Beta / (1+(1-Tax Rate)*(Total Debt/Total Equity))
For the next step, you will relever this median number to find the levered beta for Walmart.
Step 5: Calculate cost of equity
We now have all the required inputs to calculate the equity cost. According to the equation above, we can calculate the cost of equity.
Step 6: Calculate the weighted average cost of capital (WACC)
Applying the WACC formula give us the final estimated WACC of 4.05%
We hope that after reading this article, we have a clear direction on how to calculate WACC, given how important it is to understanding and valuing a company. As you can see, WACC calculation is not definite. A lot of steps are grounded heavily in assumptions both internally and externally depending on the amount of information at your disposal. We hope that the article addresses all the nuances you’ll encounter in your calculations and shows you how to navigate them.