How to Calculate WACC

Step by step WACC calculation with example.

1. How to Calculate WACC
By:
Mohamed Zohair
[email protected]
March, 2015

2. Expected Return
Free Risk Return Rf
Market Return Rm High Risk
3% 7% Expected return> 7%

3. Definitions
Return
•Rfis the return expected from the absolutely risk-free investment
•Rmis the return expected from the market
variance
•Covariance measure of the degree to which returns on two risky
assets move in tandem
•Variance how far each number in the set is from the mean

4. The weighted average cost of capital (WACC)
•For any firm the capital structure consists of equity and debt
•Weighted value of each portion is
•Equity / Value E/V
•Debt / Value D/V
•The WACC formula is
WACC = Ke(E/V) + Kd(D/V) (1-Tc)
whereKeis cost of equity
Kdis cost of debt
Tcis Tax rate
Equity
Debt
Value = E + D

5. Common Question Sample
•ABCcompany is aiming to expand their business by establishing a new
production plant XYZ. This project will cost the company £xx million.
With given information; Calculate the weighted average cost of capital (WACC).

6. Given information
Equity
Debt
New Company
Equity
Debt
Existing Company
Common Given Information
•Rf
•Rm
•Covariance
•Variance
•Tax rate
•Existing Company
•Cost of equity (Ke)
•Capital Structure
•New Company
•Cost of dept (Kd)
•Capital Structure

7. Calculation Formulas
For Existing Company
-Step 1: Beta = Covariance / Variance
-Step 2: Ke= Rf+ Beta ( Rm-Rf)
-Step 3: WACC = Ke(E/V) + Kd(D/V) (1-Tc)
To avoid the effect of debt (leveraged), we need to calculate the value
of Unleveraged Beta
-Step 4: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc)
Equity
Debt
Equity
Debt
Existing Company New Company
For New Company
-Step 5: calculate new company Beta using formula # 4
-Step 6: Ke= Rf+ Beta ( Rm-Rf)
-Step 7: WACC = Ke(E/V) + Kd(D/V) (1-Tc)
1
2
3
4
2
3

8. Sample # 1
Common Given Information
•Rf= 7%
•Rm= 16%
•Covariance = 1.5%
•Variance = 1%
•Tax rate = 40 %
Companies information
•Company EAM(Existing)
•Cost of equity (Ke) ??
•Capital Structure D/E = 1.2
•Company DA(New)
•Cost of dept (Kd) = 10%
•Capital Structure
60 % Equity & 40 % Debt

9. Sample Requirements
For Existing Company
-Step 1: Beta = Covariance / Variance
-Step 2: Ke= Rf+ Beta ( Rm-Rf)
-Step 3: WACC = Ke(E/V) + Kd(D/V) (1-Tc)
To avoid the effect of debt (leveraged), we need to calculate the value
of Unleveraged Beta
-Step 4: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc) Equity
Debt
Equity
Debt
EAM DA
For New Company
-Step 5: calculate new company Beta using formula # 4
-Step 6: Ke= Rf+ Beta ( Rm-Rf)
-Step 7: WACC = Ke(E/V) + Kd(D/V) (1-Tc)
1
2
3
4
2
3

10. Sample Solution
(a)Calculate beta & Keof EAM
-Step 1: Beta = Covariance / Variance
= 1.5 / 1
= 1.5
-Step 2: Ke= Rf+ Beta ( Rm-Rf)
= 0.07 + (1.5) (.09)
= 0.07 + .135
= 0.205
= 20.5%
Equity
Debt
D/E = 60 /40 = 1.5
Cost of dept (Kd) = 10%
Equity
Debt
D/E= 1.2
EAM DA

11. Sample Solution
(b) unleverageBeta of EAM
Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc)
= 1.5 / [1 + (1.2) (.6)
= 1.5 / [1 + .72]
= 1.5 / 1.72
= 0.8721 Equity
Debt
D/E = 60 /40 = 1.5
Cost of dept (Kd) = 10%
Equity
Debt
D/E= 1.2
EAM DA

12. Sample Solution
(c) Leverage Beta & Keof DA
Step 1: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc)
Hence, Beta (leverage, Da) = Beta (unleverage, EAM) x [1 + (D/E) (1-Tc)]
= 0.8721 x [ 1 + (1.5) (.6) ]
= 0.8721 x [ 1+ .9)
= 0.8721 x 1.9
= 1.6569
Note that, the D/E here for DA
-Step 2: Ke= Rf+ Beta ( Rm-Rf)
= 0.07 + (1.6569) (.09)
= 0.07 + .1491
= 0.2191
= 21.91%
Equity
Debt
D/E = 60 /40 = 1.5
Cost of dept (Kd) = 10%
Equity
Debt
D/E= 1.2
EAM DA

13. Sample Solution
(d) WACC of DA
Step 1: WACC = Ke(E/V) + Kd(D/V) (1-Tc)
= (0.2191) (.6) + (0.1) (.4) (.6)
= .1314 + 0.024
= .1554
= 15.54% Equity
Debt
D/E = 60 /40 = 1.5
Cost of dept (Kd) = 10%
Equity
Debt
D/E= 1.2
EAM DA

14. Summary
4 Formulas
Beta = Covariance / Variance
Ke= Rf+ Beta ( Rm-Rf)
WACC = Ke(E/V) + Kd(D/V) (1-Tc)
Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc)
5 Common Given Information
•Rf
•Rm
•Covariance
•Variance
•Tax rate
3 of 4 Companies Given Information
•Company (Existing)
•Cost of equity (Ke)
•Capital Structure
•Company (New)
•Cost of dept (Kd)
•Capital Structure

15. Exam Tips
(1)The cost of debt and D/E may be given as information inside the credit
rating agency table as below,
Based on the company rate, get the D/E and cost of debt directly from
table. Say, the company rated as BBB, that means E/D = .75 and Kd= 9.5%

16. Exam Tips
(2) The existing company has no debts
That means,
Beta (unleverage) = Beta (leverage), and
WACC = Ke
(3) XYZ company will issue a 5 year bond with an annual coupon of 12%
of the nominal-value of the bond.
Even thought they will issue bond for 5 years, the cost of debt still
12% (annually)