# 3.4. Weighted Average Cost of Capital (WACC)

#### Capital structure

Before advancing into the WACC, you need to understand what is the capital structure. The capital of a company can include equity and debt. Be aware that in this sense, debt only comprises the “interest-bearing” debt. That means not every liability is considered debt, only the liabilities that imply paying some form of interest: bank loans are considered debt, but the suppliers accounts are not debt in this sense.

Combined, equity and debt comprise 100% of a company’s capital – it’s source of financing. Hence, the capital structure of a company refers to the weight that equity has within capital and to the weight of debt within capital. The weight of equity is given by:

• $$Weight\ of\ equity=\ \frac{E}{E+D}$$

Where:

• E: equity value
• D: debt value

The weight of Debt is given by:

• $$Weight\ of\ debt=\ \frac{D}{E+D}$$

If you add the weight of equity to the weight of debt you will have total capital:

• $$\frac{D}{E+D}+\frac{E}{E+D}\ =\ 1$$
##### Leveraged and unleveraged companies

Companies can be solely financed by equity, but the opposite is not true; companies cannot be solely financed by debt. A company that only holds equity in its capital structure is called unlevered. A company that holds both equity and debt is called levered.

#### WACC

If capital is composed of equity and debt, then the cost of financing a company is a function of its cost of equity and its cost of debt: the weighted average cost of Capital (WACC). As its nomenclature indicates the WACC matches the weight of equity and the weight of debt.

• $$WACC=\frac{E}{E+D}r_e+\frac{D}{E+D}r_d(1-t)$$

Where:

Notice that the cost of debt used in the WACC is after-corporate tax.

#### Example case: Dutch Fabric Innovations

In order to calculate its WACC, DFI needs to estimate the equity weight, the debt weight, the cost of equity and the cost of debt, so that it is possible to apply the WACC formula.

The equity and the debt weights are obtained according to the debt-to-equity ratio of the industry. The debt-to-equity ratio of the industry presents the value of 35% and serves as a proxy for all the companies in the industry, including those that are not publicly listed, just like DFI.

We know that the ratio that gives us the equity weight, for example, is $$\frac{E}{D+E}$$ . By dividing both numerator and denominator by E and using the debt-to-equity ratio, we reach an equity weight of around 26%. Analogously, the debt weight will be 74%.

As for the cost of debt and equity, we know that the first equals 2.25% from previous calculations. The cost of equity will be equal to 7.65%, given a risk-free asset of 1%, a beta of 0.95 and a market risk premium of 7%.

After defining these four elements, and knowing that the Netherlands have a Corporate tax rate of 25%, we can finally obtain WACC:

• WACC = (0.26 x 0.0765) + (0.74 x 0.0225) x (1 – 0.25) = 6.25%

#### Example case: Golden Days

To calculate the WACC, Golden Days needs to have the equity and debt weights, as well as the cost of equity and debt. After finding good estimates for these elements, the WACC formula can be applied.

For this company, the equity weight will be equal to 100% for the first five years of the project because the Golden Days does not incur into debt during this period. Given this, the debt weight will be 0%.

As for the cost of debt and equity, we know that the first equals 1.75%, considering that the estimated interest rate is 2.5% and the corporate tax rate is 30%. The cost of equity will be equal to 7%, given a risk-free asset of 2%, market risk premium of 4% and a beta of 1.25. The beta is the one from the industry and the risk-free asset and the market risk premium are values that correspond to the whole market.

All of this being said, and considering that New York applies a corporate tax rate of around 30%, we can finally use the formula to obtain the Weighted Average Cost of Capital:

• WACC = (100% x 7%) + (0% x 1.75%) = 7%

We must note that, when calculating the cost of debt, the tax shield has already been applied and, therefore, we do not need to include it again in the WACC formula.