What is WACC? Calculating the Weighted Average Cost of Capital

WACC represents a firm's average cost of return for its securities. It is the discount rate used in DCF models to determine the present value of cash flows.

The Weighted Average Cost of Capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. It is the minimum return a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital. For valuation professionals, WACC is the standard discount rate applied to future cash flows in a Discounted Cash Flow (DCF) analysis.

The formula for WACC is: $WACC = \left( \frac{E}{V} \times Re \right) + \left( \frac{D}{V} \times Rd \times (1 - Tc) \right)$. In this equation, $E$ is the market value of equity, $D$ is the market value of debt, $V$ is the total value ($E + D$), $Re$ is the cost of equity, $Rd$ is the cost of debt, and $Tc$ is the corporate tax rate. The $(1 - Tc)$ term accounts for the Tax Shield, as interest payments on debt are tax-deductible in jurisdictions like the United States.

To determine the cost of equity ($Re$), firms typically use the Capital Asset Pricing Model (CAPM). This requires calculating the company's Beta ($\beta$), which measures the stock's sensitivity to market movements. If a company has a $\beta$ of 1.2, it is 20% more volatile than the broad market. A higher $\beta$ increases the $Re$, which in turn raises the WACC and lowers the current valuation of the firm's future cash flows.