This document is an authorized copy for the course Executive MBA BRA 2023-2025 - Executive MBA BRA 2023-2025
- Corporate Finance - B taught by prof. Belisario, Pedro Henrique at IESE B.
FN-604-E
March 2013
Formulas Involved in WACC Calculations
1. Objective
Which discount rate should a company use to evaluate its projects or to value its assets in
general? The discount rate should be the rate that a company expects to pay, on average, to
all its security holders to finance its assets (i.e., shareholders and debt holders). This rate is
known as the weighted average cost of capital (WACC). This is intended to clarify the
different assumptions and formulas used to calculate the WACC that you will encounter in
different textbooks and articles.
2. The WACC Formula
The WACC formula is a weighted average of the cost of equity and the after-tax cost of debt:
1 (1)
In this formula, RE is the expected cost of equity, RD is the expected cost of debt, is the
corporate tax rate, E is the market value of the firm’s equity and D is the market value of the
firm’s debt. Note that, usually, V is said to be the sum of debt and equity; therefore, V=D+E.
Sometimes, not all financing is provided by debt and equity. For example, some companies
also use preferred stock in addition to equity and debt. The WACC formula needs to be
modified to include the main sources of a firm’s long-term financing, such as preferred stock:
where RP is the cost of preferred stock and P is the market value of the firm’s preferred stock.
This technical note was prepared by Professor Carles Vergara Alert and Pedro Saffi, Professor at the Judge Business
School. March 2013.
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Last edited: 5/19/14
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This document is an authorized copy for the course Executive MBA BRA 2023-2025 - Executive MBA BRA 2023-2025 - Corporate Finance - B taught by prof. Belisario, Pedro Henrique at IESE B.
FN-604-E Formulas Involved in WACC Calculations
3. Using the WACC Formula
It is straightforward to obtain most of the values for the variables in the WACC formula (we
will focus on formula (1) going forward):
• The market value of the firm’s equity (E) can be simply estimated as the value of the firm’s
shares times the number of shares.
• The book value of the firm’s debt can be used as a proxy for the market value of the firm’s
debt (D).
• The corporate tax rate is given (e.g., =34% can be used as a proxy for the federal tax rate
in the United States). Let V denote the sum of the firm’s equity and the book value of debt.
Therefore, V=E+D and let D/V denote the leverage ratio for the firm.
• The cost of debt, RD, should reflect the reality of the company. Each company knows its
debt rate premium: the spread over the government bond’s rate that lenders require in order
to lend capital to the firm.1 Therefore, RD = (RF + Company’s debt premium), where RF is the
current risk-free interest rate with a maturity that is similar to the projects we are
considering.
However, if the company changes its leverage ratio (D/V), we need to do a little bit of extra
work. Each time the leverage ratio changes, we must recalculate a new expected cost of
equity, RE. As leverage increases, the risk to shareholders also increases and, as a result, they
also require a higher rate of return. In general, we should follow two steps to recalculate RE if
the leverage ratio of a company changes:
First, we must unlever RE, by dividing returns into two parts: part of RE is compensation for
operational risk and part is compensation for the financial risk due to having leverage. This
compensation for operational risk is denoted RA. It measures the expected return on equity as if
the company had no leverage, i.e., as if the firm had no debt. This is also known as the
“unleveraged” firm return.2 Knowing the equity return (RE) and the debt return (RD) of the firm, it
is straightforward to calculate the expected return on assets (RA) using the following formula:3
1 . (2)
Note that in the formula above, our unknown is the RA, where R is the current cost of
equity for the firm. Therefore, solving for RA, equation (2) becomes:
. (3)
1 This is equivalent of saying, for example, that you know how many basis points over the LIBOR a bank will charge you if you
borrow from them (e.g., if you get a mortgage). Obviously, it is easy to obtain the value of the spread over the treasury that they
will charge you: you just have to ask a few banks.
2 Thus, for a company that has no debt, RE=RA.
3 We can estimate RE from financial market data. We can obtain it from a data provider (e.g. Bloomberg, Datastream) using the
CAPM model.
2 IESE Business School-University of Navarra
This document is an authorized copy for the course Executive MBA BRA 2023-2025 - Executive MBA BRA 2023-2025 - Corporate Finance - B taught by prof. Belisario, Pedro Henrique at IESE B.
Formulas Involved in WACC Calculations FN-604-E
Second, we must relever RE. If the company has the same operational risk regardless of its
capital structure, we can use the RA to estimate the new cost of equity, R , which accounts
for the new capital structure of the company. Unlike the previous equation, we now take RA
as a given and compute the new return on equity given the updated leverage ratio.
1 . (4)
Thus, we have seen how to estimate all of the variables needed to compute the WACC: E, D, ,
RD and RE.
4. Conclusions
Two main conclusions can be drawn from this note. First, you should always use the two-
step method (Step 1: unlever RE; Step 2: relever RA) to calculate the proper cost of equity, RE,
in the WACC formula. This must be done whenever the company has a different leverage
ratio than the one used to calculate the original RE.
IESE Business School-University of Navarra 3
