Module XVIII·Article II·~3 min read
WACC
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WACC: Company Cost of Capital
Weighted Average Cost of Capital (WACC) is the weighted average cost of capital, used as the discount rate in DCF. WACC reflects the minimum return that a company must generate in order to satisfy all capital providers.
WACC Formula
$ \text{WACC} = \frac{E}{V} \times R_e + \frac{D}{V} \times R_d \times (1-T) $
| Component | Description | Source/Calculation |
|---|---|---|
| E/V | Equity share | Market Cap / (Market Cap + Debt) |
| D/V | Debt share | Debt / (Market Cap + Debt) |
| Re | Cost of equity | CAPM or Build-up method |
| Rd | Cost of debt | YTM on existing debt |
| T | Tax rate | Effective or statutory rate |
CAPM: Calculating Re
$ R_e = R_f + \beta \times (R_m - R_f) + \text{Size Premium} + \text{Country Premium} $
| Component | Description | Typical value |
|---|---|---|
| Rf | Risk-free rate (10Y Treasury) | 4-5% |
| $\beta$ | Beta — sensitivity to market | 0.8-1.5 |
| Rm - Rf | Equity Risk Premium | 5-6% |
| Size Premium | For small caps | 0-3% |
| Country Premium | For EM | 0-5% |
WACC Calculation Example
| Parameter | Value |
|---|---|
| Market Cap (E) | $1,000M |
| Debt (D) | $500M |
| E/V | 67% |
| D/V | 33% |
| Rf | 4.5% |
| $\beta$ | 1.2 |
| ERP | 5.5% |
| Re = 4.5% + 1.2 × 5.5% | 11.1% |
| Rd (YTM) | 6.0% |
| T | 25% |
| After-tax Rd | 4.5% |
| WACC | $67% \times 11.1% + 33% \times 4.5% = 8.9%$ |
Beta: How to Measure
| Method | Description | Pros/Cons |
|---|---|---|
| Regression Beta | Regression of returns vs market | Historical, may not reflect future |
| Industry Beta | Industry average | More stable, less accurate for specific company |
| Unlevered → Relevered | Adjust for capital structure | More correct for comparisons |
Unlevering and Relevering Beta
$ \beta_{unlevered} = \frac{\beta_{levered}}{1 + (1-T) \times D/E} $
$ \beta_{relevered} = \beta_{unlevered} \times [1 + (1-T) \times D/E] $
Typical WACC by Sector
| Sector | WACC Range | Characteristics |
|---|---|---|
| Utilities | 5-7% | Low beta, high leverage, regulated |
| Consumer Staples | 7-9% | Low beta, stable cash flows |
| Healthcare | 8-10% | Medium beta, growth |
| Technology | 10-14% | High beta, growth uncertainty |
| Biotech | 12-18% | Very high beta, binary outcomes |
| EM Companies | 12-20% | Country premium |
Problems with WACC
| Problem | Impact | Solution |
|---|---|---|
| Rf choice | 10Y vs 30Y vs real? | Match to investment horizon |
| ERP choice | Historical vs implied? | Use multiple sources, be consistent |
| Beta unstable | Changes over time | Use industry betas, adjust for leverage |
| Capital structure | Changes | Use target structure |
CIO Recommendations
- Consistency — use the same methodology for comparisons
- Sensitivity — test different WACC
- Reasonableness check — WACC should make sense
- Industry benchmarks — compare to peers
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