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Weighted average cost of capital (WACC) is a basic financial concept and formula that is frequently used in corporate finance and sometimes used in equity and debt valuation, although understanding what it is and its limitations is usually more beneficial to the external analyst trying to understand how a company thinks about itself and its future.

To understand this, let’s do a quick rundown of WACC. This formula tells you how much a firm must pay for debt and equity, with common stock, preferred stock, bonds, and other debt weighted accordingly to reach their total cost.

The formula is as follows: WACC = E/V * Re + D/V * Rd * (1-Tc)

E is the market value of the company’s equity

D is the market value of the company’s debt

V = E + D

Re = Cost of equity

Rd = Cost of debt

Tc = Tax rate for the company

To clarify, let’s use an example. Imagine a company with a market cap of $1 billion in common stock that owes $50 million in debt. Already, we know three variables here:

E = $1 billion

D = $50 million

V = $1,050 million

Now Rd is easy: we just look at the company’s interest expense (listed on their 10-Qs and 10-Ks) and divide it by the total debt load. If the cost of debt is $2 million per year for this company, then Rd = 4%.

Tc is even easier: most companies will tell you their tax rate in their SEC filings. If they don’t, just look at the company’s total taxes paid and divide that by pre-tax income. For our example, let’s say the Tc is 10%.

That just leaves Re, which is a bit harder to calculate. To do so, analysts typically (but not always!) refer to the capital asset pricing model (CAPM), in which the risk-free rate is added to the investment’s beta multiplied by expected market return minute market risk premium, or:

Re = Rf + B (MR – RP)

Rf = risk-free rate

B = investment beta

MR = expected market return

RP = risk premium

This will tell us the expected return on equity for this particular investment.

For the risk-free rate, let’s use the 10-year U.S. Treasury which is now at about 2.7%. Let’s say that the investment we are looking at is expected to be 10% riskier than the market, meaning the B = 1.1 (since 1 = same risk as the market). The expected market return for common stock is usually 7%, so let’s go with that for MR. Finally, let’s say our risk premium will be 1% to compensate for the greater risk of B = 1.1.

Now we’re ready to do some simple math:

Re = 2.7% + 1.1(7%-1%) = 2.7% = 9.3%.

And now, with everything in place, we can finally do our WACC calculation:

WACC = 1,000/1050 * .093 + 50/1050 * .04 * (1-.10)

or

WACC = 9.03%

(Note that the formula above simplifies billions and millions into thousands, but the end result is the same).

Doing this calculation on the corporate finance side, the analyst can then tell his boss that the company should not consider any investment that will not yield a 9.03% return on investment. On the external analyst side, however, one would run this analysis and (more importantly) look at the corporate finance analysis of WACC with some critical questions, mostly going back to the CAPM model.

For starters, is the risk-free rate assumption correct? Using a 10-year risk-free rate assumption for a 20-year investment, for instance, doesn’t make sense, but some analysts will try to fudge the RFR to get the result they want. Similarly, is the investment beta calculated honestly? There is a lot of leeway here, as companies can weight the volatility of debt more than equity in a CAPM model to get a more preferable result, and external analysts should be on the lookout for this. Similarly, is the expected market return and risk premium honest?

Making these numbers more generous can change things a lot. For instance, if our MR goes from 7% (the S&P 500 historical norm) to 3%, our WACC goes from 9.03% to 4.4%! All of a sudden, a slew of investment opportunities look more attractive, and can justify good investments that really are not that good.

This brings us to the primary lesson of the WACC formula: because it has numbers, it looks empirical and objective, but the assumptions in Re bring a lot of subjectivity into the equation (this is why the CAPM model is rejected by some analysts in some situations). Understanding how the WACC formula is used in a firm can teach you a lot about how healthy its financial future will be and how honest management is, while running these analyses for yourself to assess the success of a company’s past investment activity can also tell you whether management has deployed capital wisely or made major missteps.