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Weighted-Average Cost of Capital (WACC)

 Unlevered Free Cash Flow (unlevered­fcf) Terminal Value  (terminal­value)

The rate used to discount future unlevered free cash flows (UFCFs) and the terminal value (TV) to
their present values should reflect the blended after-tax returns expected by the various providers
of capital. The discount rate is a weighted-average of the returns expected by the different classes
of capital providers (holders of different types of equity and debt), and must reflect the long-term
targeted capital structure as opposed to the current capital structure. While a separate discount rate
can be developed for each projection interval to reflect the changing capital structure, the discount
rate is usually assumed to remain constant throughout the projection period.

In situations where projections are judged to be aggressive, it may be appropriate to use a higher
discount rate than if the projections are deemed to be more reasonable. While choosing the
discount rate is a matter of judgment, it is common practice to use the weighted-average cost of
capital (WACC) as a starting point.

Considerations in Calculating WACC Related / Recommended Topics

Discounted Cash Flow (DCF) Overview
The following are important considerations when calculating WACC: (overview)
Unlevered Free Cash Flow (unlevered­fcf)
WACC must comprise a weighted-average of the marginal costs of all sources of capital (debt,
equity, etc.) since UFCF represents cash available to all providers of capital. Terminal Value (terminal­value)
WACC must be computed after corporate taxes, since UFCFs are computed after-tax. Enterprise and Equity Values (enterprise­
equity­values)
WACC must use nominal rates of return built up from real rates and expected inflation, because
the expected UFCFs are expressed in nominal terms.
WACC must be adjusted for the systematic risk borne by each provider of capital, since each (/macros)
expects a return that compensates for the risk assumed.
While calculating the weighted-average of the returns expected by various providers of capital,
market value weights for each financing element (equity, debt, etc.) must be used, because
market values reflect the true economic claim of each type of financing outstanding whereas
book values may not.
Long-term WACCs should incorporate assumptions regarding long-term debt rates, not just
current debt rates.

Calculation of WACC × for Excel  (/macros)

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E D P
WACC = × re + × (1 − t) × rd + × rp
(E+D+P) (E+D+P) (E+D+P)

Where:

E = Market value of equity

D = Market value of debt
P = Market value of preferred stock
re = Cost of equity
rd = Cost of debt
rp = Cost of preferred stock
t = Marginal tax rate

The market values of equity, debt, and preferred should reflect the targeted capital structure, which
may be different from the current capital structure. Even though the WACC calculation calls for the
market value of debt, the book value of debt may be used as a proxy so long as the company is not
in financial distress, in which case the market and book values of debt could differ substantially.
Multiplying the debt term in the WACC equation by (1−t) captures the benefit of the tax shield
arising from interest expense.

Calculating the Cost of Equity

The cost of equity is usually calculated using the capital asset pricing model (CAPM), which defines
the cost of equity as follows:

re = rf + β × (rm − rf)

Where:

rf = Risk-free rate (represented by 10-yr U.S. Treasury bond rate)

β = Predicted equity beta (levered)
(rm − rf) = Market risk premium

The market risk premium has historically averaged around 7%

and the risk-free rate around 4%.

Beta is a measure of the volatility of a stock's returns relative to

the equity returns of the overall market. It is determined by
plotting the stock's and market's returns at discrete intervals
over a period of time and fitting (regressing) a line through the
resulting data points. The slope of that line is the levered equity
beta. When the slope of the line is 1.00, the returns of the stock
are no more or less volatile than returns on the market. When
the slope exceeds 1.00, the stock's returns are more volatile
than the market's returns.

Predicted Beta
Equity betas can be obtained from the Barra Book. These betas will be levered and either historical Excel Shortcuts PDF
or predicted. The historical beta is based on actual trading data for the period examined (often 2 (/ExcelShortcuts.pdf)
years), while the predicted beta statistically adjusts the historical beta to reflect an expectation that
an individual company's beta will revert toward the mean over time. For example, if a company's
historical beta is less than 1.00, then the predicted beta will be greater than the historical beta but
less than 1.00. Similarly, if the historical beta is greater than 1.00, the predicted beta will be less
than the historical beta but greater than 1.00. It is generally advisable to use predicted beta.

Betas of comparable companies are used to estimate re of private companies, or where the shares
of the company being valued do not have a long enough trading history to provide a good estimate
of the beta.

Predicted beta may be calculated using one of two methods:

(A) Using the company's beta:

1. De-lever the beta using the following formula:

Levered β
Unlevered β =
1 + [(D/E) × (1−t) + P/E]

Where:

E = Market value of existing equity

D = Market value of existing debt
P = Market value of existing preferred stock

2. Re-lever the unlevered β with the targeted capital structure (typically reflecting an average
capital structure for the industry, not the capital structure for the individual company) using the
formula:

Levered β = Unlevered β × [1 + [(D/E) × (1−t) + P/E]]

 Where:

Levered β = β used in CAPM formula for re

E = Market value of targeted equity
D = Market value of targeted debt
P = Market value of targeted preferred stock

(B) Using betas of comparable companies:

1. De-lever the comparable companies' betas using the formula stated above. Use each
comparable company's existing capital structure to de-lever its beta.
2. Calculate the average unlevered beta of the comparable companies.
3. Re-lever the average unlevered beta using the formula above. Use the company's targeted
capital structure to re-lever the average unlevered beta.

Unlevered Free Cash Flow (unlevered­fcf) Terminal Value (terminal­value)

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