Ashish Agarwal
Agile Coach, Scrum Master, Technology Evangelist, Blogger and Lifetime Learner
Published Oct 4, 2023
The cost of equity calculated using CAPM is a critical input in the WACC calculation. WACC considers the costs of both equity and debt financing, and the cost of equity derived from CAPM represents the cost of equity financing. Therefore, CAPM plays a key role in determining the equity portion of the WACC, which in turn affects the overall WACC used in various financial analyses.
Calculating WACC using Weights and Costs of Debt and Equity
Let's calculate the Weighted Average Cost of Capital (WACC) using weights and costs of debt and equity:
WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt * (1 - Tax Rate)
Hypothetical Example: Calculating WACC
Assume we have a company called "ABC Inc." with the following information:
Market value of equity (E): $80 million
Market value of debt (D): $40 million
Cost of equity (Re): 12%
Cost of debt (Rd): 6%
Corporate tax rate: 25%
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Calculations
Calculate the weights of equity and debt:
Weight of Equity = Market Value of Equity / (Market Value of Equity + Market Value of Debt)
Weight of Debt = Market Value of Debt / (Market Value of Equity + Market Value of Debt)
Weight of Equity = $80M / ($80M + $40M) = 0.6667 (rounded to 4 decimal places)
Weight of Debt = $40M / ($80M + $40M) = 0.3333 (rounded to 4 decimal places)
Calculate the WACC using the provided formula:
WACC = Weight of Equity Cost of Equity + Weight of Debt Cost of Debt * (1 - Tax Rate)
WACC = (0.6667 0.12) + (0.3333 0.06 * (1 - 0.25))
WACC = 0.08 + 0.015
WACC = 0.095 or 9.5%
Interpretation
In this hypothetical example, ABC Inc.'s WACC is calculated to be 9.5%. This means that ABC Inc. needs to generate a return of at least 9.5% on its projects and investments to cover the costs of both equity and debt financing. The WACC is a useful metric for evaluating the company's potential investment opportunities, as projects with returns above the WACC are considered attractive, while projects with returns below the WACC may not be worth pursuing.
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