WACC: Cost of Capital and Discount Rate

WACC as the discount rate in DCF
Weighted Average Cost of Capital (WACC) is the weighted average cost of a company's capital, used as the discount rate in the DCF model. WACC reflects the required return for all capital providers, considering their share in the financing structure.

Formula for WACC
WACC = (E/V) × Re + (D/V) × Rd × (1 - T), where:
E — market value of equity;
D — market value of debt;
V = E + D — total capital value;
Re — cost of equity;
Rd — cost of debt (before taxes);
T — corporate income tax rate.

Tax Shield:
Interest payments on debt are deducted from the tax base, so the effective cost of debt = Rd × (1 - T).

Capital Structure:
Weights (E/V and D/V) must be market-based, not book-based.

Cost of Equity (Re)
CAPM model:
Re = Rf + β × (Rm - Rf), where
Rf — risk-free rate,
β — systematic risk of the stock relative to the market,
(Rm - Rf) — equity risk premium (ERP).

Risk-free rate:
Yield on 10-year government bonds. For USD valuations — US Treasury.

Beta:
A measure of a stock's volatility relative to the market.
β = 1 means it moves with the market; β > 1 — more volatile.

Levered vs Unlevered Beta:
Unlevered β = Levered β / (1 + (1-T) × D/E).

Equity Risk Premium (ERP):
Historically 5-7% for developed markets.

Cost of Debt (Rd)
Pre-tax cost of debt:
Yield to maturity (YTM) on company bonds or rate on new loans of a comparable rating.

Corporate spreads:
Rd = Rf + Credit Spread. Spread depends on credit rating.

For private companies: synthetic rating is applied based on Interest Coverage Ratio.

Key mistakes in WACC

• Using book weights instead of market weights.
• Confusing WACC with cost of debt.
• Incorrect tax shield.
• Circular reference: resolved by iteration or target D/E.

Sensitivity analysis for WACC:
A change in WACC by 1% can alter the valuation by 15-25%.
A table is constructed with EV/Equity Value for various combinations of WACC and Terminal Growth Rate.