WACC: The Building Blocks

Step 1: Cost of Equity

Re = Rf + (β × ERP)

Where: Rf = risk-free rate, β = levered beta, ERP = equity risk premium.

Using the risk-free rate (4.0%), beta (1.2), and equity risk premium (5.5%):

Re = 4.0% + (1.2 × 5.5%) = 4.0% + 6.6% = 10.6%

The cost of equity is the return shareholders require for holding the company's stock, given its systematic risk. It's the piece of WACC driven purely by equity risk — beta scales the overall market risk premium up or down based on how volatile this company's returns are relative to the market.

Step 2: After-Tax Cost of Debt

Rd (after-tax) = Rd × (1 - T)

Using the pre-tax cost of debt (6.0%) and tax rate (25%, 0.25):

Rd (after-tax) = 6.0% × (1 - 0.25) = 6.0% × 0.75 = 4.5%

Debt is cheaper than equity in part because interest payments are tax-deductible — the after-tax rate captures that tax shield. This is why WACC uses the after-tax, not pre-tax, cost of debt: ignoring the shield would overstate the true cost of a company's debt financing.

Step 3: Market-Value Weights

Weight of Equity = E / (D + E), Weight of Debt = D / (D + E)

Using the market value of equity ($800m) and market value of debt ($200m):

Weight of Equity = 800 / (200 + 800) = 800 / 1,000 = 80.0% (0.80)

Weight of Debt = 200 / (200 + 800) = 200 / 1,000 = 20.0% (0.20)

These weights must use market values, not book values — book value of equity reflects historical accounting, not what the company is actually worth today, and lenders and analysts care about the capital structure the company is actually financed with right now.

Step 4: WACC

WACC = (E/(D+E) × Re) + (D/(D+E) × Rd × (1 - T))

Where: E/(D+E) = weight of equity, D/(D+E) = weight of debt, Re = cost of equity, Rd = after-tax cost of debt.

Using the weight of equity (80.0%), cost of equity (10.6%), weight of debt (20.0%), and after-tax cost of debt (4.5%):

WACC = (0.80 × 10.6%) + (0.20 × 4.5%) = 8.48% + 0.90% = 9.38%

WACC represents the blended return a company must generate on its assets to satisfy both shareholders and lenders — it's the discount rate used to bring a company's projected free cash flows back to present value in a DCF. A higher WACC lowers the present value of future cash flows, so getting each building block right (cost of equity, after-tax cost of debt, and market-value weights) directly changes a company's estimated valuation.

Final Results

• Cost of Equity (Re): 10.6%
• After-Tax Cost of Debt: 4.5%
• Weight of Equity / Debt: 80.0% / 20.0%
• WACC: 9.38%

This WACC is the discount rate you'd apply to the company's unlevered free cash flows and terminal value in a DCF to arrive at enterprise value.

Would you like to explore how WACC changes as the company takes on more debt, and why WACC doesn't keep falling indefinitely as leverage increases?