Step by step WACC calculation with example.

1. How to Calculate WACC
By:
Mohamed Zohair
Moh.zohair@gmail.com
March, 2015

2. Expected Return
Free Risk Return Rf Market Return Rm High Risk
3% 7% Expected return> 7%

3. Definitions
Return
• Rf is the return expected from the absolutely risk-free investment
• Rm is the return expected from the market
variance
• Covariance measure of the degree to which returns on two risky
assets move in tandem
• Variance how far each number in the set is from the mean

4. The weighted average cost of capital (WACC)
• For any firm the capital structure consists of equity and debt
• Weighted value of each portion is
• Equity / Value  E/V
• Debt / Value  D/V
• The WACC formula is
WACC = Ke (E/V) + Kd (D/V) (1-Tc)
where Ke is cost of equity
Kd is cost of debt
Tc is Tax rate
Equity
Debt
Value = E + D

5. Common Question Sample
• ABC company is aiming to expand their business by establishing a new
production plant XYZ. This project will cost the company £xx million.
With given information; Calculate the weighted average cost of capital (WACC).

6. Given information
Equity
Debt
New Company
Equity
Debt
Existing Company
Common Given Information
• Rf
• Rm
• Covariance
• Variance
• Tax rate
• Existing Company
• Cost of equity (Ke)
• Capital Structure
• New Company
• Cost of dept (Kd)
• Capital Structure

7. Calculation Formulas
For Existing Company
- Step 1: Beta = Covariance / Variance
- Step 2: Ke = Rf + Beta ( Rm - Rf)
- Step 3: WACC = Ke (E/V) + Kd (D/V) (1-Tc)
To avoid the effect of debt (leveraged), we need to calculate the value
of Unleveraged Beta
- Step 4: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc)
Equity
Debt
Equity
Debt
Existing Company New Company
For New Company
-Step 5: calculate new company Beta using formula # 4
-Step 6: Ke = Rf + Beta ( Rm - Rf)
- Step 7: WACC = Ke (E/V) + Kd (D/V) (1-Tc)
1
2
3
4
2
3

8. Sample # 1
Common Given Information
• Rf = 7%
• Rm = 16%
• Covariance = 1.5%
• Variance = 1%
• Tax rate = 40 %
Companies information
• Company EAM (Existing)
• Cost of equity (Ke) ??
• Capital Structure  D/E = 1.2
• Company DA (New)
• Cost of dept (Kd) = 10%
• Capital Structure
60 % Equity & 40 % Debt

9. Sample Requirements
For Existing Company
- Step 1: Beta = Covariance / Variance
- Step 2: Ke = Rf + Beta ( Rm - Rf)
- Step 3: WACC = Ke (E/V) + Kd (D/V) (1-Tc)
To avoid the effect of debt (leveraged), we need to calculate the value
of Unleveraged Beta
- Step 4: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc) Equity
Debt
Equity
Debt
EAM DA
For New Company
-Step 5: calculate new company Beta using formula # 4
-Step 6: Ke = Rf + Beta ( Rm - Rf)
- Step 7: WACC = Ke (E/V) + Kd (D/V) (1-Tc)
1
2
3
4
2
3

10. Sample Solution
(a) Calculate beta & Ke of EAM
- Step 1: Beta = Covariance / Variance
= 1.5 / 1
= 1.5
-Step 2: Ke = Rf + Beta ( Rm - Rf)
= 0.07 + (1.5) (.09)
= 0.07 + .135
= 0.205
= 20.5%
Equity
Debt
D/E = 60 /40 = 1.5
Cost of dept (Kd) = 10%
Equity
Debt
D/E = 1.2
EAM DA

11. Sample Solution
(b) unleverage Beta of EAM
Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc)
= 1.5 / [1 + (1.2) (.6)
= 1.5 / [1 + .72]
= 1.5 / 1.72
= 0.8721 Equity
Debt
D/E = 60 /40 = 1.5
Cost of dept (Kd) = 10%
Equity
Debt
D/E = 1.2
EAM DA

12. Sample Solution
(c) Leverage Beta & Ke of DA
Step 1: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc)
Hence, Beta (leverage, Da) = Beta (unleverage, EAM) x [1 + (D/E) (1-Tc)]
= 0.8721 x [ 1 + (1.5) (.6) ]
= 0.8721 x [ 1+ .9)
= 0.8721 x 1.9
= 1.6569
Note that, the D/E here for DA
-Step 2: Ke = Rf + Beta ( Rm - Rf)
= 0.07 + (1.6569) (.09)
= 0.07 + .1491
= 0.2191
= 21.91%
Equity
Debt
D/E = 60 /40 = 1.5
Cost of dept (Kd) = 10%
Equity
Debt
D/E = 1.2
EAM DA

13. Sample Solution
(d) WACC of DA
Step 1: WACC = Ke (E/V) + Kd (D/V) (1-Tc)
= (0.2191) (.6) + (0.1) (.4) (.6)
= .1314 + 0.024
= .1554
= 15.54% Equity
Debt
D/E = 60 /40 = 1.5
Cost of dept (Kd) = 10%
Equity
Debt
D/E = 1.2
EAM DA

14. Summary
4 Formulas
Beta = Covariance / Variance
Ke = Rf + Beta ( Rm - Rf)
WACC = Ke (E/V) + Kd (D/V) (1-Tc)
Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc)
5 Common Given Information
• Rf
• Rm
• Covariance
• Variance
• Tax rate
3 of 4 Companies Given Information
• Company (Existing)
• Cost of equity (Ke)
• Capital Structure
• Company (New)
• Cost of dept (Kd)
• Capital Structure

15. Exam Tips
(1) The cost of debt and D/E may be given as information inside the credit
rating agency table as below,
 Based on the company rate, get the D/E and cost of debt directly from
table. Say, the company rated as BBB, that means D/E = .75 and Kd = 9.5%

16. Exam Tips
(2) The existing company has no debts
That means,
Beta (unleverage) = Beta (leverage), and
WACC = Ke
(3) XYZ company will issue a 5 year bond with an annual coupon of 12%
of the nominal-value of the bond.
 Even thought they will issue bond for 5 years, the cost of debt still
12% (annually)