The Weighted Average Cost of Capital (WACC) of a company represents the cost of acquiring additional capital based on the current capital structure. It is essentially the rate of return the business is expected to generate for it’s investors going forward. The WACC can therefore be used to discount future expected earnings in order to arrive at the value of those future cash flows in today’s dollars.
The WAAC formula:
Ke – Cost of Equity
This is the unlevered rate of return that equity investors expect from holding shares in the company. It is based on the level of risk associated with the investment if the company held no debt. In a startup context this is a very tricky number to determine. For public companies we can estimate this required rate of return using the capital asset pricing model.
Kd – Cost of Debt
The cost of debt represents the rate of return a new debt holder would demand when lending money to the company. It’s important to remember that this is different than the current rate of interest on debt held by the company. Debt in the company may have been issued years before in different market conditions then are prevalent today and therefore would have been issued at different interest rates.
If you’re analyzing a large public company you can determine the cost of debt from the yield on outstanding bonds. Otherwise, you’ll need to find debt in a company with a comparable risk and capital structure in order to infer the cost of debt. Easier said then done in the startup world.
E – total market value of equity
For a public company this is the market capitalization of the company which is available on most financial websites. Coming up with this value for a startup is another difficult decision.
D – total market value of interest bearing debt
This is the interest bearing debt which you can grab directly from the balance sheet. The only time when the carrying value on the balance sheet will not represent the fair value of debt is when the company is in extreme financial distress and may default on some of it’s liabilities.
t – Tax rate
This is the marginal rate of tax paid by the company. The marginal tax rate represents the tax rate which will be paid on the next dollar of income. You can determine the marginal tax rate by looking at the financial statements and considering the tax law in the jurisdiction relevant to the company.
We need to average both the cost of debt and equity because our discretionary cash flows relate to the entire value of the business
The allocation between the total fair market value of debt and equity should theoretically be based on the optimal structure. However we ignore that here because we assume to have no control over the capital structure and also to make the calculation easier.
We multiply the cost of debt by (1-t) to incorporate the tax saving that interest payments provide
The cost of equity is based on the expected return of an unlevered company since our valuation models are based on unlevered discretionary cash flows