Lesson 2 of 5
Where each WACC input comes from
Five inputs make a WACC. Two are read from a filing, one is a share price, one is derivable two ways, and one is an estimate nobody files.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Five inputs make a weighted average cost of capital, and each is read from a different place, or not filed anywhere.
- Equity is read from a share price, with book debt standing in for market debt.
- The cost of equity has no document behind it, and it is usually the input the whole answer turns on.
The formula is short: WACC blends the cost of equity and the after-tax cost of debt, weighted by how much of each the company uses. Where each of those five pieces actually comes from is a more useful question than what the letters stand for.
One company's capital, by market value
Paid first
- Debt, interest-bearing borrowings$20020%
- Equity, shares outstanding times price$80080%
Paid last
Total$1,000
Five inputs, one line each
| Input | What it is | Where it is read |
|---|---|---|
| E | Market value of equity | Shares outstanding (cover page), adjusted for options and convertibles, times today's share price |
| D | Market value of debt | Interest-bearing debt on the balance sheet, book value stands in for market value |
| Re | Cost of equity | Not filed anywhere; usually built from a risk-free rate, a beta and an equity risk premium |
| Rd | Cost of debt | Interest expense over average debt (the derived route), or a bond's yield to maturity (the market route) |
| Tc | Tax rate | The marginal rate: 21 percent federal plus any state tax, or the effective rate from the tax note |
Debt is read from the balance sheet, short and long term including the current portion, and the share count from the cover page. The share price is a fact but not a filed one, and it moves daily, which is why a WACC computed today and one computed last month differ for reasons that have nothing to do with the business. Book equity, what the company raised historically plus what it retained, is not the equity weight here: this formula wants what the equity is worth now.
Rd, two ways to read it
The derived route divides interest expense by the average of interest-bearing debt across two balance sheets. Every input is filed, and it gives you the average rate the company is paying on debt it borrowed in the past. The market route reads the yield to maturity on the company's traded bonds, where it has any, which is what the company would pay to borrow today.
When the two disagree by a lot, the disagreement is itself information. A company paying 3 percent on old debt whose bonds now yield 9 percent has a refinancing problem that the derived figure hides completely.
The one input with no source
The cost of equity is the estimate the answer usually turns on. Most of the time it comes from the capital asset pricing model, which needs a risk-free rate that is observable, a beta that is measured rather than filed, and an equity risk premium that is not observable at all. Later lessons in this course take those two apart on their own, because each one moves a valuation more than tightening the arithmetic here ever could.
Check yourself
Which of the five WACC inputs has no document behind it anywhere?
- Rd, the cost of debt
- Tc, the tax rate
- Re, the cost of equity
Show the answer
Answer: C.
The risk-free rate, beta and the equity risk premium inside it are observed, measured or estimated, never filed as a single stated figure.The market value of equity in this formula is best measured as:
- Total shareholders' equity on the balance sheet
- Diluted shares outstanding times the current share price
- Net income divided by the cost of equity
Show the answer
Answer: B.
Book equity is what was raised and retained historically. The weight in this formula is meant to reflect what the equity is worth right now.Why is the cost of debt multiplied by (1 minus the tax rate)?
- Because dividends are tax deductible
- Because interest is deductible against corporate tax, lowering its true cost
- Because debt is always cheaper than equity
Show the answer
Answer: B.
A company paying 5 percent on debt at a 21 percent tax rate is really paying 3.95 percent, because the interest deduction reduces its tax bill.Sources
- Sharpe's capital asset pricing model, for the structure the cost of equity is usually built on.
- 26 U.S.C. section 11(b): the US federal statutory corporate tax rate, 21 percent.
What this leaves out
- Preference shares, convertible instruments, leases and minority interests are all capital, and none of them appears in this formula. A company with a lot of any of them needs a longer version of it.
- Book value stands in for the market value of debt. When bonds trade below par it overstates the debt weight, and when they trade above par it understates it.
- The interest deduction is capped and needs taxable income to use.
- Beta and the equity risk premium are estimates supplied by whoever builds the rate, not figures this page provides.
- Nothing here is advice about any security.