FIN509 • Chapter 14: Weighted Average Cost of Capital (WACC)

1) What is WACC?

WACC is the firm’s blended required return on the capital it uses to fund core operating assets. It averages the cost of equity, debt, and (if any) preferred stock, weighted by their market values.

Plain English: Projects earning more than WACC create value; below WACC destroy value.

2) Why does WACC matter?

Hurdle rate for NPV/IRR decisions.
Discount rate for FCFF valuation.
Performance yardstick (ROIC − WACC).
Capital structure trade‑offs (tax shield vs. risk).

3) Overview & Learning Links

Start here: watch the short video, then try the game/quiz/calculators.

🎮 WACC Interactive Game 📊 WACC Calculator (Annual) 📈 WACC Calculator (Semi‑Annual)

4) The WACC formula

WACC = w_E·R_E + w_D·R_D·(1 − T) + [optional] w_P·R_P

Weights sum to 1 and are based on market values.
R_E via CAPM or DDM; R_D is the marginal borrowing rate (YTM), then after‑tax.
Exclude excess cash from V if focusing on core operations.

5) Estimating the inputs

Cost of Equity CAPM

R_E = r_f + β·(E[R_M] − r_f)

Or DDM (Gordon): R_E ≈ D₁/P₀ + g

Cost of Debt YTM

Use the current YTM on new borrowing (not the coupon).
After‑tax: R_D,after = R_D,pre·(1−T).

Weights Market Values

w_i = value_i / (E + D + P − Cash).

Housekeeping

Use a target D/E if transitioning.
Confirm marginal tax rate.

6) WACC Calculator & Company Presets

Illustrative only. Load a preset, hit Compute WACC, then tweak.

Capital Structure (market values)

Equity, E (billions) Market cap

Debt, D (billions) Interest‑bearing

Preferred, P (billions) If any

Excess Cash (billions) Optional (exclude)

Costs & Tax

Cost of Equity, R_E (%) e.g., CAPM

Pre‑tax Cost of Debt, R_D (%) YTM

Cost of Preferred, R_P (%) Div ÷ Price

Tax Rate, T (%) Marginal

Weights: —

Presets (Illustrative)

After loading, click Compute WACC. The detailed math appears below.

7) Worked Examples

Annual coupon case

10‑yr, 5% coupon, price $950, flotation $40, tax 34%. Dividend $2, price $40, equity flotation $4, g=10%. 50/50 D/E.

K_D = RATE(10, 50, −(950−40), 1000) × (1−0.34)

K_E = 2 / (40−4) + 10%

WACC = 0.5·K_D + 0.5·K_E = 9.84%

Semi‑annual coupon case

K_D = RATE(20, 25, −(950−40), 1000) × 2 × (1−0.34)

K_E = 2 / (40−4) + 10%

WACC ≈ 9.84%

8) Company Type ↔ Debt & WACC

Company Type	Debt Level	WACC Level	Reasoning	Example
Startup	Low	High	High risk, limited cash flow → equity funding preferred.	Early‑stage tech startup
High‑Tech	Low–Moderate	High	High growth & risk, avoid debt burden.	Biotech firm
Retail	Moderate–High	Moderate	Stable cash flows allow some leverage.	Supermarket chain
Utility	High	Low–Moderate	Predictable cash flows support heavy debt, lowering WACC.	Electric company
Manufacturing	Moderate	Moderate	Balanced capital structure common.	Auto manufacturer
Matured Firm	High	Low	Stable, predictable → low WACC.	Coca‑Cola

9) GuruFocus WACC Links

Use as a starting point; always verify inputs (β, r_f, MRP, YTM, T) with primary sources.

10) Quick quiz (instant feedback)

Q1. True/False — In WACC, the weight on debt should use the book value of debt because interest is fixed by contract.

Q2. Which is the correct after‑tax debt cost term in WACC?

Q3. You computed a project IRR of 8% and firm WACC of 10%. Accept or reject?

11) Notes & extras

Assign: source β, r_f, MRP, YTM, T and justify.
Try a target D/E versus current structure.
Run ±1% sensitivity on R_E and R_D.

Chapter 14 — Weighted Average Cost of Capital (WACC)