The Weighted Average Cost of Capital (WACC)

Sarah Martin

30 years: Corporate Valuations

In this video, Sarah introduces the concept of the Weighted Average Cost of Capital (WACC), which plays a critical role in discounted cash flow (DCF) valuations. She explains how to calculate WACC using the costs of debt and equity, how to apply market-based weights, and how to handle key complexities such as sovereign spreads and funding in different currencies.

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The Weighted Average Cost of Capital (WACC)

11 mins 38 secs

Key learning objectives:

Understand the concept and role of WACC in enterprise valuations
Identify how to calculate WACC using debt and equity components
Understand how market values and tax effects influence WACC
Learn how to adjust for sovereign spreads and hybrid instruments

Overview:

The weighted average cost of capital (WACC) is the discount rate used in enterprise valuations within a DCF framework. It reflects the average return required by all capital providers (both debt and equity holders), weighted by their relative market values. WACC is sensitive to the long-run cost of debt, the effective tax rate, and the required return on equity. Sarah explains how to handle common issues like circularity in enterprise value, the need for market-based weights, sovereign risk adjustments, and calculating WACC for firms with complex capital structures.

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Summary

What is WACC and why is it important in valuations?
WACC represents the average return that all capital providers debt and equity expect for investing in a firm. It is the discount rate used in enterprise-level DCF valuations to convert future cashflows into a present value.

How is WACC calculated?
The formula weights the cost of debt and cost of equity by their share in the capital structure (based on market values, not book values). The after-tax cost of debt reflects the deductibility of interest in most tax systems.

What are the components of WACC?

Cost of debt: Usually taken as the long-run cost (e.g. 5–10-year bonds), adjusted for tax
Cost of equity: Often estimated using the CAPM
Weightings: Based on market value of debt and equity, not book values

Why do we use market values instead of book values?
Investors base valuations on what they pay in the market. Book values may under- or overstate reality especially for equity, which is often materially different from its market capitalisation.

What if we don’t know the enterprise value (EV) to calculate the weights?

This creates a circularity problem as WACC needs EV, but EV depends on WACC. To overcome this, there are two ways:

Use the firm’s target capital structure for the weights
Use a multiple-based valuation to approximate EV and then derive weights

How does taxation affect the cost of debt?
Since interest payments are typically tax-deductible, the cost of debt is adjusted by (1 – tax rate). If the firm has tax loss carry-forwards, you still use the normal effective tax rate in the WACC.

What if the capital structure includes other instruments?
In addition to debt and equity, firms may issue preferred shares or hybrid instruments like convertible bonds. These must be factored in, each with their own cost and weighting.

How does sovereign risk impact the risk-free rate?
In countries with sub-AAA sovereign ratings, you must add a sovereign spread to the risk-free rate. For example, valuing an Italian firm in euros involves adding the spread of Italian government bonds over German Bunds.

How do you deal with debt in multiple currencies?
Always base the cost of debt on the currency used for the valuation. If the valuation is in US dollars, use the USD cost of debt, even if the firm borrows in other currencies the FX impact will be reflected in market values.

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Sarah Martin

Sarah Martin has a degree in economics from the London School of Economics and stock exchange and regulatory qualifications from London and New York. She has worked in investment banking for 17 years, as well as private equity transactions and as an expert witness in financial trials. She became a financial trainer 15 years ago and specialises in credit, distressed debt, and valuation. Recent assignments have included the European Central Bank, the European Investment Bank, the EBRD, Gibbs Business School in Johannesburg, the Bahrain Institute of Business Finance, the Bank of China, BBVA, the African Development Bank, Siemens, Carnegie Bank, Rand Merchant Bank, the Hamburg Central Bank, and Mizuho Bank.

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