Lesson 2 of 2
Where each WACC input comes from
Five inputs, one line each. Two are read from a filing, one is a share price, one is derivable, and the fifth is an estimate that no document anywhere contains.
By Javier SanzPublished
Founder of ValueScreener. Built and sold Ninety Nine, a retail brokerage, and ran operations at Alpaca, the brokerage API. Built an earlier version of this product that did everything and earned nothing.
The formula is short.
WACC = (E / V) x Re + (D / V) x Rd x (1 - Tc)
E is the market value of equity, D the market value of debt, V is E plus D. Re is the cost of equity, Rd the cost of debt before tax, Tc the marginal tax rate. This lesson is about where each of those five actually comes from, which is a more useful question than what the letters stand for.
E, the market value of equity
Shares outstanding times the share price.
Shares outstanding is on the cover page of the annual report and again in the equity note. Use the current diluted count, not the weighted average used for earnings per share: you are measuring the equity that exists now, not the equity that existed on average last year.
The share price is a fact but not a filed one, which matters more than it sounds. It moves daily, so a cost of capital computed today and a cost of capital computed last month are different numbers for reasons that have nothing to do with the business.
Not book equity. Book equity is what the shares raised historically plus what was retained. The weight in this formula is meant to be what the equity is worth now, and for most companies the two are not close.
D, the market value of debt
Interest-bearing debt, short-term and long-term, from the balance sheet. Add the current portion of long-term debt, which sits in current liabilities and is easy to miss.
Not accounts payable, not accruals, not deferred revenue. Those are operating liabilities. They fund the business and they carry no interest, and including them overstates the debt weight while pushing the average down through a component that has no cost.
Book value is the standard stand-in for market value here, because most corporate debt is not quoted. That is an approximation, and for a company whose bonds trade well below par it is a bad one. It is still small next to the uncertainty in the cost of equity, which is the next input.
Re, the cost of equity
This is the one with no document behind it.
Most people build it with the capital asset pricing model:
Re = Rf + beta x (Rm - Rf)
Rf is the risk-free rate and it is observable: a government bond yield at a maturity matching your forecast horizon. Beta is a measured quantity, but the measurement depends on which index you measure against, over what period, and at what frequency, and the reasonable choices give visibly different answers for the same company. The equity risk premium, Rm minus Rf, is not observable at all. It is an estimate of what investors as a group require above the risk-free rate, and the published estimates differ from each other by more than the figure moves in a decade.
So the cost of equity is an estimate built on an estimate, and it is usually the input the whole answer turns on. The useful response is not to find a better source. It is to compute the valuation at both ends of the range you would defend and see whether the conclusion survives.
Rd, the cost of debt
Two ways to get it, and they answer different questions.
The derived one: interest expense from the income statement, divided by the average of interest-bearing debt at the start and end of the year from two balance sheets. Every input is filed. What it gives you is the average rate the company is paying on debt it borrowed in the past.
The market one: the yield to maturity on the company's traded bonds, where it has any. This is what the company would pay to borrow now, which is the number the formula actually wants, because the cost of capital is forward-looking.
When they disagree by a lot, the disagreement itself is 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.
Tc, the tax rate
The marginal rate, meaning the rate that applies to the next unit of interest deducted. The US federal statutory corporate rate is 21% (26 U.S.C. 11(b)), which is the rate the Internal Revenue Code sets.
A company's effective rate is different, often very different, and the reconciliation between the statutory rate and the effective rate is in the income tax note. Read it before choosing. A rate that is low because of a one-off item is not the rate that will apply to next year's interest deduction; a rate that is low because of where the company books its profits probably is.
Putting it together
Take the illustrative case: equity worth 800, debt worth 200, cost of equity 9 percent, cost of debt 5 percent, tax at 21 percent.
| Step | Value |
|---|---|
| Total capital, E + D | 1,000 |
| Equity weight, E / V | 80.00% |
| Debt weight, D / V | 20.00% |
| After-tax cost of debt, 5% x (1 - 0.21) | 3.95% |
| Equity contribution, 80% x 9% | 7.20% |
| Debt contribution, 20% x 3.95% | 0.79% |
| Weighted average cost of capital | 7.99% |
Look at what the last three rows say. The equity side supplies 7.20 of the 7.99. The debt side, which is where most of the reading was, supplies 0.79. An answer that is nine tenths cost of equity is an answer that is nine tenths estimate, and it is worth saying so out loud in whatever you write next to the number.
What this leaves out
The formula treats the company as one thing with one cost of equity and one cost of debt. A group with materially different divisions, or one funded in several currencies, usually needs a rate per division, and the single figure above will average them into something that describes none of them.
Preference shares, convertible instruments, leases and minority interests are all capital, and none of them appears in this formula. Any of them can be large enough to change the answer, and a company with a lot of any of them needs a longer version of it.
Book value standing in for the market value of debt understates the debt weight when bonds trade below par. Beta and the equity risk premium are estimates and are treated here as inputs you supply, not as figures this page provides.
Nothing here is advice about any security.