WACC

What is WACC, its formula, and why it's used in corporate finance

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Definition of WACC
A firm’s Weighted Average Cost of Capital (WACC) represents its
blended cost of capital across all sources, including common shares,
preferred shares, and debt. The cost of each type of capital is weighted by its
percentage of total capital and then are all added together. This guide will
provide a detailed breakdown of what WACC is, why it is used, and how to
calculate it.

WACC is used in financial modeling as the discount rate to calculate the net
present value of a business. More specifically, WACC is the discount rate
used when valuing a business or project using the unlevered free cash
flow approach. Another way of thinking about WACC is that it is the required
rate an investor needs in order to consider investing in the business.
Learn more: CFI’s Business Valuation Resources.

What is the WACC Formula?

As shown below, the WACC formula is:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate

An extended version of the WACC formula is shown below, which includes

the cost of preferred stock (for companies that have preferred stock).

The purpose of WACC is to determine the cost of each part of the

company’s capital structure based on the proportion of equity, debt and
preferred stock it has. Each component has a cost to the company. The
company usually pays a fixed rate of interest on its debt and usually a fixed
dividend on its preferred stock. Even though a firm does not pay a fixed rate
of return on common equity, it does often pay cash dividends.

The weighted average cost of capital is an integral part of a DCF valuation

model and, thus, it is an important concept to understand for finance
professionals, especially for investment banking, equity
research and corporate development roles. This article will go through each
component of the WACC calculation.

WACC Part 1 – Cost of Equity

The cost of equity is calculated using the Capital Asset Pricing Model
(CAPM) which equates rates of return to volatility (risk vs reward). Below is
the formula for the cost of equity:

Re = Rf + β × (Rm − Rf)

Where:

Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield)
β = equity beta (also known as the levered beta)
Rm = annual return of the stock market

The cost of equity is an implied cost or an opportunity cost of capital. It is the

rate of return an investor requires in order to compensate for the risk of
investing in the stock. Beta is a measure of a stock’s volatility of returns
relative to the overall stock market (often proxied by a large stock index like
the S&P 500 index). If you have the data in Excel, beta can be easily
calculated using the SLOPE function. See below for more on beta.

Risk-free Rate
The risk-free rate is the return that can be earned by investing in a risk-free
security, e.g., U.S. Treasury bonds. Typically, the yield of the 10-year U.S.
Treasury is used for the risk-free rate. It’s called risk free because it is free
from default risk; however, other risks like interest rate risk still apply.

Equity Risk Premium (ERP)

The equity risk premium (ERP) is defined as the extra yield that can be
earned over the risk-free rate by investing in the stock market. One simple
way to estimate ERP is to subtract the risk-free return from the market
return. This information will normally be enough for most basic financial
analysis. However, estimating the ERP can be a much more detailed task in
practice. Generally, banks take the ERP from publications by Morningstar or
Kroll (formerly known as Duff and Phelps).

Levered Beta
Beta refers to the volatility or riskiness of a stock relative to all other stocks
in the market. There are a couple of ways to estimate the beta of a stock.
The first and simplest way is to calculate the company’s historical beta
(using regression analysis). Alternatively, there are several financial data
services that publish betas for companies.
The second, and more thorough, approach is to make a new estimate for a
company’s beta using public company comparables. To use this approach,
the beta of comparable companies is taken from one of the financial data
services. Then the unlevered beta for each company is calculated using the
following formula:

Unlevered Beta = Levered Beta / ((1 + (1 – Tax Rate) * (Debt /

Equity))

The levered beta includes both business risk and the risk that comes from
taking on debt. However, since different firms have different capital
structures, the unlevered beta (also known as the asset beta) is calculated to
remove additional risk from debt in order to view pure business risk. The
average of the unlevered betas is then calculated and re-levered based on
the capital structure of the company that is being valued:

Levered Beta = Unlevered Beta * ((1 + (1 – Tax Rate) * (Debt /

Equity))

In most cases, the firm’s current capital structure is used when beta is re-
levered. However, if there is information that the firm’s capital structure
might change in the future, then beta would be re-levered using the firm’s
target capital structure.

After calculating the risk-free rate, equity risk premium, and levered beta,
the cost of equity = risk-free rate + equity risk premium * levered beta.
Learn more: CFI’s Business Valuation Resources.

WACC Part 2 – Cost of Debt and Preferred Stock

Determining the cost of debt and preferred stock is probably the easiest part
of the WACC calculation. The cost of debt is the yield to maturity on the
firm’s debt. Similarly, the cost of preferred stock is the dividend yield on the
company’s preferred stock. Simply multiply the cost of debt and the yield on
preferred stock with the proportion of debt and preferred stock in a
company’s capital structure, respectively.

Since interest payments are tax-deductible, the cost of debt needs to be

multiplied by (1 – tax rate), which is referred to as the value of the tax shield.
This is not done for preferred stock because preferred dividends are paid
with after-tax profits.

Take the weighted average current yield to maturity of all outstanding debt
then multiply it one minus the tax rate and you have the after-tax cost of
debt to be used in the WACC formula.

Learn the details in CFI’s Math for Corporate Finance Course.

WACC Calculator
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What is WACC used for?

The Weighted Average Cost of Capital serves as the discount rate for
calculating the value of a business. It is also used to evaluate investment
opportunities, as WACC is considered to represent the firm’s opportunity cost
of capital. Thus, it is used as a hurdle rate by companies.
A company will commonly use its WACC as the hurdle rate for evaluating
mergers and acquisitions (M&A), as well as for financial modeling of internal
investments. If an investment opportunity has a lower Internal Rate of
Return (IRR) than its WACC, it should not invest in the project and may
choose to buy back its own shares or pay out a dividend to shareholders.

Nominal vs Real Weighted Average Cost of Capital

Nominal free cash flows (which include inflation) should be discounted by a
nominal WACC and real free cash flows (excluding inflation) should be
discounted by a real weighted average cost of capital. Nominal is more
common in practice, but it’s important to be aware of the difference.

Use in Valuation
WACC is used as the discount rate when performing a valuation using
the unlevered free cash flow (UFCF) approach. Discounting UFCF by WACC
derives a company’s implied enterprise value. Equity value can then be be
estimated by taking enterprise value and subtracting net debt. To obtain
equity value per share, divide equity value by the fully diluted shares
outstanding.

Learn more: CFI’s Business Valuation Resources.

Limitations of WACC
Despite it’s prevalence in corporate finance, WACC does have several
limitations:

1. Difficult to measure in practice: Despite the above discussion,

some of the inputs to WACC are difficult to measure in practice and
require analyst judgment. For example, an analyst must come up with
a realistic list of comparable companies if the analyst wants to
calculate a company’s levered beta.
2. Difficult to apply to a specific project: WACC is usually calculated
at the corporate level, using the corporation’s cost of equity and target
capital structure. However, calculating the WACC of individual
investments a company is considering may or may not have the same
risk-and-return characteristics of the parent company. A workaround
for this is for a company to add a margin of error to its corporate-level
WACC to account for the potentially higher risk of the individual
investments.
3. Use of historical data: Valuation is forward looking but many of the
inputs to WACC are based on historical data. For example, the equity
 risk premium is almost always based on past data, as is beta.
Therefore, WACC implicitly assumes the past will continue in to the
future, which is obviously not always the case.
4. Private companies: Although it’s possible to calculate WACC for
private companies, it is more difficult, especially around cost of equity.
This can be mitigated by using the comparable company approach to
calculating beta that was discussed earlier. Additionally, a private
company’s cost of debt may be proxied by looking at the cost of debt
of similarly credit-rated companies.
Career Paths
Many professionals and analysts in corporate finance use the weighted
average cost of capital in their day-to-day jobs. Some of the main careers
that use WACC in their regular financial analysis include:

 Investment Banking
 Equity Research
 Corporate Development
 Private Equity

Learn more about the cost of capital from Kroll.

What is a Discount Rate?

In corporate finance, a discount rate is the rate of return used to discount
future cash flows back to their present value. This rate is often a
company’s Weighted Average Cost of Capital (WACC), required rate of
return, or the hurdle rate that investors expect to earn relative to the risk of
the investment.
Other types of discount rates include the central bank’s discount window
rate and rates derived from probability-based risk adjustments.

Why is a Discount Rate Used?

A discount rate is used to calculate the Net Present Value (NPV) of a business
as part of a Discounted Cash Flow (DCF) analysis. It is also utilized to:

 Account for the time value of money

 Account for the riskiness of an investment
 Represent opportunity cost for a firm
 Act as a hurdle rate for investment decisions
 Make different investments more comparable
Types of Discount Rates
In corporate finance, there are only a few types of discount rates that are
used to discount future cash flows back to the present. They include:

 Weighted Average Cost of Capital (WACC) – for calculating

the enterprise value of a firm
 Cost of Equity – for calculating the equity value of a firm
 Cost of Debt – for calculating the value of a bond or fixed-income
security
 A pre-defined hurdle rate – for investing in internal corporate projects
 Risk-Free Rate – to account for the time value of money
Discount Rate Example (Simple)
Below is a screenshot of a hypothetical investment that pays seven annual
cash flows, with each payment equal to $100. In order to calculate the net
present value of the investment, an analyst uses a 5% hurdle rate and
calculates a value of $578.64. This compares to a non-discounted total cash
flow of $700.

Essentially, an investor is saying “I am indifferent between receiving $578.64

all at once today and receiving $100 a year for 7 years.” This statement
takes into account the investor’s perceived risk profile of the investment and
an opportunity cost that represents what they could earn on a similar
investment.

Hurdle Rate Definition

A hurdle rate is the minimum rate of return that must be achieved

What is a Hurdle Rate?

A hurdle rate, which is also known as the minimum acceptable rate of return
(MARR), is the minimum required rate of return or target rate that investors
are expecting to receive on an investment.

The hurdle rate is determined by assessing the cost of capital, risks involved,
current opportunities in business expansion, rates of return for similar
investments, and other factors that could directly affect an investment.

Before accepting and implementing a certain investment project, its internal

rate of return (IRR) should be equal to or greater than the hurdle rate. Any
potential investment must possess a return rate that is higher than the
hurdle rate in order for it to be acceptable in the long run.
What are the Methods Used to Determine a Hurdle Rate?
Most companies use their weighted average cost of capital (WACC) as a
hurdle rate for investments. This stems from the fact that companies can
buy back their own shares as an alternative to making a new investment,
and would presumably earn their WACC as the rate of return. In this way,
investing in their own shares (earning their WACC) represents the
opportunity cost of any alternative investment.

Another way of looking at the hurdle rate is that it’s the required rate of
return investors demand from a company. Therefore, any project the
company invests in must be equal to or ideally greater than its cost of
capital.

A more refined approach is to look at the risk of individual investments and

add or deduct a risk premium based on that. For example, a company has a
WACC of 12% and half its assets are in Argentina (high risk), and half its
assets are in the United States (low risk).

If the company is looking at one new investment in Argentina and one new
investment in the United States, it should not use the same hurdle rate to
compare them. Instead, it should use a higher rate for the investment in
Argentina and a lower one for the investment in the U.S.

What are the Factors to Consider when Setting a Hurdle

Rate?
In analyzing a potential investment, a company must first hold a preliminary
evaluation to test if a project has a positive net present value. Care must be
exercised, as setting a very high rate could be a hindrance to other profitable
projects and could also favor short-term investments over long-term ones. A
low hurdle rate could also result in an unprofitable project.

Key considerations include:

 Risk premium – Assigning a risk value for the anticipated risk

involved with the project. Riskier investments generally have greater
hurdle rates than less risky ones.
 Inflation rate – If the economy is experiencing mild inflation, that
may influence the final rate by 1%-2%. There are instances when
inflation may be the most significant factor to consider.
 Interest rate – Interest rates represent an opportunity cost that could
be earned on another investment, so any hurdle rate needs to be
compared to real interest rates.
How to Use the Hurdle Rate to Evaluate an Investment
The most common way to use the hurdle rate to evaluate an investment is
by performing a discounted cash flow (DCF) analysis. The DCF analysis
method uses the concept of the time value of money (opportunity cost) to
forecast all future cash flows and then discount them back to today’s value
to provide the net present value.

In order to do this, the company needs to perform some financial modeling.

The first step is to model out all the revenues, expenses, capital costs, etc.,
in an Excel spreadsheet and develop a forecast. The forecast needs to
include the free cash flow of the investment over its lifetime.

Once all the cash flows are in place, use the XNPV function in Excel to
discount the cash flows back to today at the set hurdle rate. If the resulting
Net Present Value (NPV) is greater than zero, the project exceeds the hurdle
rate, and if the NPV is negative, it does not meet it.

As you can see in the example above, if a hurdle rate (discount rate)
of 12% is used, the investment opportunity has a net present value
of $378,381. This means if the cost of making the investment is less than
$378,381, then its expected return will exceed the hurdle rate. If the cost is
more than $378,381, then the expected return will be lower than the hurdle
rate.

Learn more about rates of return in CFI’s financial modeling & valuation
courses.

How Important is the Hurdle Rate in Capital Investments?

The hurdle rate is often set to the weighted average cost of capital (WACC),
also known as the benchmark or cut-off rate. Generally, it is utilized to
analyze a potential investment, taking the risks involved and the opportunity
cost of foregoing other projects into consideration.

One of the main advantages of a hurdle rate is its objectivity, which prevents
management from accepting a project based on non-financial factors. Some
projects get more attention due to popularity, while others involve the use of
new and exciting technology.

What are the Limitations of Using a Hurdle Rate?

It’s not always as straightforward as picking the investment with the highest
internal rate of return. A few important points to note are:

 Hurdle rates can favor investments with high rates of return, even if
the dollar amount (NPV) is very small.
 They may reject huge dollar-value projects that may generate more
cash for the investors but at a lower rate of return.
 The cost of capital is usually the basis of a hurdle rate, and it may
change over time.
 Discounted Cash Flow
(DCF)
An analysis method used to value investment by discounting the estimated
future cash flows

What is Discounted Cash Flow (DCF)?

Discounted cash flow (DCF) is an analysis method used to value investments
by discounting the estimated future cash flows. DCF analysis can be applied
to value a stock, company, project, and many other assets or activities, and
thus is widely used in both the investment industry and corporate finance
management.

Summary
 Discounted cash flow (DCF) evaluates investment by discounting the
estimated future cash flows.
 A project or investment is profitable if its DCF is higher than the initial cost.
 Future cash flows, the terminal value, and the discount rate should be
reasonably estimated to conduct a DCF analysis.
Understanding DCF Analysis
DCF analysis estimates the value of return that investment generates after
adjusting for the time value of money. It can be applied to any projects or
investments that are expected to generate future cash flows.

The DCF is often compared with the initial investment. If the DCF is greater
than the present cost, the investment is profitable. The higher the DCF, the
greater return the investment generates. If the DCF is lower than the present
cost, investors should rather hold the cash.

The first step in conducting a DCF analysis is to estimate the future cash
flows for a specific time period, as well as the terminal value of the
investment. The period of estimation can be your investment horizon. A
future cash flow might be negative if additional investment is required for
that period.
Then, you need to determine the appropriate rate to discount the cash flows
to a present value. The cost of capital is usually used as the discount rate,
which can be very different for different projects or investments. If a project
is financed through both debt and equity, the weighted-average cost of
capital (WACC) approach can apply.

Calculation of Discounted Cash Flow (DCF)

DCF analysis takes into consideration the time value of money in a
compounding setting. After forecasting the future cash flows and
determining the discount rate, DCF can be calculated through the formula
below:

The CFn value should include both the estimated cash flow of that period and
the terminal value. The formula is very similar to the calculation of net
present value (NPV), which sums up the present value of each future cash
flow. The only difference is that the initial investment is not deducted in DCF.

Here is an example for better understanding. A company requires a

$150,000 initial investment for a project that is expected to generate cash
inflows for the next five years. It will generate $10,000 in the first two years,
$15,000 in the third year, $25,000 in the fourth year, and $20,000 with a
terminal value of $100,000 in the fifth year. Assuming the cost of capital is
5%, and no further investment is required during the term, the DCF of the
project can be calculated as below:

Without considering the time value of money, this project will create a total
cash return of $180,000 after five years, higher than the initial investment,
which seems to be profitable. However, after discounting the cash flow of
each period, the present value of the return is only $146,142, lower than the
initial investment of $150,000. It suggests the company should not invest in
the project.

Pros and Cons of Discounted Cash Flow (DCF)

One of the major advantages of DCF is that it can be applied to a wide
variety of companies, projects, and many other investments, as long as their
future cash flows can be estimated.

Also, DCF tells the intrinsic value of an investment, which reflects the
necessary assumptions and characteristics of the investment. Thus, there is
no need to look for peers for comparison.

Investors can also create different scenarios and adjust the estimated cash
flows for each scenario to analyze how their returns will change under
different conditions.

On the other hand, the use of DCF comes with a few limitations. It is very
sensitive to the estimation of the cash flows, terminal value, and discount
rate. A large amount of assumptions needs to be made to forecast future
performance.

DCF analysis of a company is often based on the three-statement model. If

the future cash flows of a project cannot be reasonably estimated, its DCF is
less reliable.

Innovative projects and growth companies are some examples where the
DCF approach might not apply. Instead, other valuation models can be used,
such as comparable analysis and precedent transactions.

Additional Resources
Thank you for reading CFI’s guide to Discounted Cash Flow (DCF). To keep
advancing your career, the additional resources below will be useful: