WACC: The Blended Cost of Capital
WACC is the return all investors collectively demand, weighted by how much capital each provides. It's the rate that discounts UFCF.
- ✓State the WACC formula and what each term means
- ✓Explain why the cost of debt is tax-affected
- ✓Describe the four building blocks you need to compute it
The Weighted Average Cost of Capital - the blended return demanded by all of a company's investors (debt and equity), weighted by each one's share of the capital structure. It's the for .
Interest is tax-deductible, so each dollar of interest saves the company in taxes. The effective is therefore . This interest tax shield is the reason debt is 'cheaper' than equity - and the reason we tax-affect separately (so we don't double-count it).
To compute you need four things: the capital weights (D/V and E/V), the cost of debt, the tax rate, and the cost of equity. The first three are mostly observable; the has to be derived - that's , next.
The weights should reflect the company's long-term target mix, not necessarily today's snapshot - a DCF assumes a constant structure over the forecast. Market values are preferred over book values (book debt is an acceptable proxy when debt trades near par).
Cost of debt is 6%, tax rate 25%. What after-tax cost of debt goes into WACC?
Blend the cost of equity and the after-tax cost of debt by their weights.
debt: 1.2%