The pieces
WACC = (E / V) x Re + (D / V) x Rd x (1 - tax rate), where E is the market value of equity, D is the market value of debt, V is E plus D, Re is the cost of equity, and Rd is the pre-tax cost of debt.
The cost of equity is usually estimated with the capital asset pricing model: the risk-free rate plus beta times the market risk premium. The cost of debt is what the company would pay to borrow today, not the coupon on bonds it issued years ago. Interest is tax deductible, so the cost of debt is multiplied by 1 minus the tax rate.
A worked example
This is an invented teaching company, not a real one. Its equity has a market value of $600 million and its debt has a market value of $400 million. The risk-free rate is 4%, the company's beta is 1.2, and the market risk premium is 5.5%. New debt would cost 6.5% before tax, and the tax rate is 25%.
| Step | Calculation | Result |
|---|---|---|
| Cost of equity (CAPM) | 4% + 1.2 x 5.5% | 10.60% |
| After-tax cost of debt | 6.5% x (1 - 0.25) | 4.875% |
| Weight of equity | $600M / $1,000M | 60% |
| Weight of debt | $400M / $1,000M | 40% |
| Equity contribution | 60% x 10.60% | 6.36% |
| Debt contribution | 40% x 4.875% | 1.95% |
| WACC | 6.36% + 1.95% | 8.31% |
The company's WACC is 8.31%. A project with the same risk as the company as a whole should be discounted at this rate, so a project earning more than 8.31% creates value.
Why the details change the answer
Forgetting the tax adjustment on debt is the most common slip. Using 6.5% instead of 4.875% in this example gives 8.96%, which is 0.65 percentage points too high and enough to flip a project from accepted to rejected. Using book values for the weights can also move the answer a lot, because the book value of equity is often far from what the stock market says the equity is worth.
Mistakes that cost points on exams
- Using the pre-tax cost of debt. The tax shield is the whole reason debt is cheaper in WACC.
- Weighting by book values when the question gives market values.
- Using the old coupon rate on existing debt instead of today's yield on similar debt.
- Treating WACC as the right rate for every project. A project that is riskier than the company needs a higher rate.
- Mixing percentages and decimals partway through, so a 10.6% rate becomes 10.6 in one place and 0.106 in another.