Weighted Average Cost of Capital

Quick Summary
1. Estimate the value of equity by using the firm’s market capitalization.
2. Calculate the market value of debt by converting the book value of debt into a hypothetical coupon bond and solving for the present value.
3. Use the statutory corporate tax rate to determine the after-tax cost of debt.
4. If applicable, add preferred stock to the WACC calculation and value the equity and debt components of convertible securities separately.

1. Market Value of Equity
The weighted average cost of capital (WACC) is used as the discount rate for free cash flows from core business activities to determine the enterprise value of a firm. It is calculated as the weighted average of the firm’s cost of equity and its after-tax cost of debt.

WACC

After determining the firm’s cost of equity and cost of debt, the remaining estimates required for calculating the WACC are the values of the firm’s equity and debt as well as the tax rate. Debt and equity values should be derived from the market when possible rather than from book or accounting values. Calculating the value of the firm’s equity is the easiest computation related to the WACC. It is the product of the number of shares outstanding times the current price per share. This is also referred to as the market capitalization.

2. Market Value of Debt
Estimating the market value of debt is usually less straightforward, namely because most firms have at least some portion of debt that is not publicly traded in the bond market. For short- and long-term debt that is being traded, market values can be found online at sites like Morningstar.com (here). Estimating the market value of non-traded debt involves treating the remaining book debt as a single hypothetical coupon bond. The coupon payment (PMT) is set equal to the firm’s interest expense (excluding the interest expense already captured by traded debt). The yield (I/Y) is the firm’s cost of debt, maturity (N) is the weighted average maturity of non-traded debt, and the par value (FV) is the book value of the non-traded debt outstanding. The market value of debt (PV) can then be estimated using a financial calculator or a spreadsheet function.

3. Corporate Tax Rate
When computing the WACC, the cost of debt must be multiplied by one minus the corporate tax rate (1 – Tc) to reflect the tax deductibility of interest payments. Although it is common to measure it by computing the firm’s average effective tax rate (=taxes / taxable income), the correct rate to use is the marginal corporate tax rate (35% in the US). Tax-loss carryforwards, investment tax credits and other factors that affect the tax rate should be judged and valued separately.

4. Preferred Stock and Convertible Bonds
In cases where a company has preferred stock outstanding, the WACC computation must be expanded to incorporate this additional component. If the preferred stock is assumed to be perpetual with a constant dividend, the cost of preferred stock can be estimated as the preferred dividend per share divided by the market price per preferred share. This rate should be somewhere between the cost of equity and debt. The market value of the preferred stock is calculated the same as for equity.

Since convertible bonds are a hybrid of debt and equity they can be disaggregated and valued by their respective components. The straight bond component is the present value of a security with the same coupon rate, maturity, and yield to maturity of similarly rated bonds (assume a par value of $1,000). The conversion option is the par value (i.e. $1,000) multiplied by the percent of par the convertible bond was issued at, less the straight bond component. Scale both preceding components to the full amount of the issued bond and add the respective amounts to the value of debt and equity.

Concluding Thoughts
Although the above analysis calculates the WACC using market value weights, it is not uncommon for analysts to use the firm’s target capital structure instead (typically found in the annual report). It is also worth bearing in mind that a firm can use more debt and increase its leverage as it matures. A stable state firm should also have a beta that converges close to one (between 0.8 and 1.2), which in turn affects its long-run cost of equity.

Suggested Reading
Pedro Carrasquillo. How to Calculate the Market Value of Debt.

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