Work it out
A company's equity is worth £600m and its debt £400m. Cost of equity is 10% and pre-tax cost of debt is 5%. What is WACC, in %?
Assumes: Tax rate of 25% (the UK main rate of corporation tax).
DCF · 4 min read
How to calculate WACC, with a worked example
WACC, the weighted average cost of capital, is the discount rate in a standard DCF. It's the blended return that all of a company's investors, lenders and shareholders, expect.
The formula
WACC = (equity weight × cost of equity) + (debt weight × cost of debt × (1 − tax rate)). The weights use market values where you can: market capitalisation for equity, and the market value of debt (often close to its book value).
A worked example
- Equity is worth £600m and debt £400m, so the weights are 60% and 40%.
- Cost of equity is 10%. Pre-tax cost of debt is 5%, so after a 25% tax rate it's 3.75%.
- WACC = 60% × 10% + 40% × 3.75% = 6.0% + 1.5% = 7.5%.
Where the cost of equity comes from
Usually CAPM: cost of equity = risk-free rate + beta × equity risk premium. In the UK, the risk-free rate is typically a long-dated gilt yield. Beta measures how much the share moves with the market; bankers often take peers' betas, remove the effect of their debt (unlevering), average them, then add back the target's own debt (relevering).
Why debt is after tax
Interest is tax-deductible for the company, so each £1 of interest costs it less than £1. That's the company's tax saving, not the lender's.
Mistakes interviewers listen for
- Forgetting the tax shield on debt.
- Using book value of equity instead of market value.
- Discounting levered free cash flow at WACC: levered cash flow belongs to shareholders, so it's discounted at the cost of equity.
Check you've got it
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