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:

• r_e: cost of equity
• r_d: cost of debt
• E: market equity value;
• D: market debt value.
• t: corporate tax rate.

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