{"concept":{"id":76,"slug":"wacc","term":"WACC","shortDefinition":"The precise calculation of the cost of capital: the weighted average of the cost of debt and the cost of equity, according to each one's weight in the company's financing.","longDefinition":"WACC (Weighted Average Cost of Capital) is the precise specialization of the cost of capital, already covered in general terms in Level 2 and used that way by ROIC and DCF. WACC combines the after-tax cost of debt and the cost of equity, each weighted by its relative share in the company's total financing: the greater the proportion of debt versus equity, the more the average leans toward debt's cost -- generally lower -- and vice versa. The result is a single discount rate, but not an exact, unquestionable figure: it depends directly on the estimates of its two components -- particularly the cost of equity, sensitive to CAPM's assumptions -- and on the financing weights used. It's the figure ROIC compares against business returns, and that DCF uses to discount its future flows, now calculated precisely instead of estimated in general terms."},"relations":{"requirement":[],"contrast":[],"related":[{"concept":{"id":60,"slug":"cost-of-capital","term":"Cost of capital","shortDefinition":"The minimum return a company should generate to justify the capital it has invested -- the benchmark ROIC is compared against.","longDefinition":"The cost of capital is the minimum return a company should generate to justify the capital it has invested -- the opportunity cost of employing that capital in this business instead of an alternative with similar risk. It's the benchmark ROIC is compared against: if a company's ROIC exceeds its cost of capital, the business is creating real value -- it generates more than it costs to finance it. If ROIC falls below the cost of capital, the business destroys value, even if it's accountably profitable and shows positive profit on its income statement."}}],"calculatedBy":[{"concept":{"id":74,"slug":"cost-of-debt","term":"Cost of debt","shortDefinition":"The effective interest rate a company pays on its financial debt, adjusted for the tax benefit of interest.","longDefinition":"Cost of debt is the effective interest rate a company pays on its financial debt -- the same financial debt, already distinguished from total liabilities, that's part of invested capital, already covered in Level 2. It isn't simply the nominal interest rate: because interest on debt is tax-deductible, the real cost the company bears is lower than the rate it pays -- the so-called \"tax shield\" of debt. That's why the cost of debt relevant to the WACC is the after-tax cost: the interest rate multiplied by (1 minus the tax rate). It's generally lower than the cost of equity, because debt is less risky for whoever provides it -- it has priority of repayment over shareholders if the company runs into trouble."}},{"concept":{"id":75,"slug":"cost-of-equity","term":"Cost of equity","shortDefinition":"The minimum return a company's shareholders demand for taking on the risk of investing in it -- not a book figure on the balance sheet.","longDefinition":"Cost of equity is the minimum return a company's shareholders demand for taking on the risk of investing in it -- a percentage, not a monetary figure. It shouldn't be confused with equity itself, already covered in Level 2: equity is a book value on the balance sheet -- what's left of assets after subtracting liabilities -- while cost of equity is a required rate of return, a completely different magnitude despite the similar names. The most widely used model for estimating it is CAPM (Capital Asset Pricing Model): it starts from the risk-free rate -- what a virtually risk-free investment would yield -- and adds a market risk premium, adjusted by the stock's beta, which measures how much its returns move relative to the market as a whole. The result depends on which risk-free rate, risk premium, and beta are used -- it's a reasoned estimate, not an exact, unquestionable figure."}}]},"curricularPosition":[{"id":63,"moduleId":22,"slug":"how-is-wacc-calculated","title":"How is WACC calculated?","summary":"You understand how the cost of debt and the cost of equity are combined, weighted by the company's financing structure, to obtain the WACC.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you understand how the cost of debt and the cost of equity are combined, weighted by the company's financing structure, to obtain the WACC.\n\n## Content\n\nThe two previous lessons developed the cost of debt and the cost of equity separately. This lesson combines them into a single figure: the WACC (Weighted Average Cost of Capital). It's the precise specialization of the cost of capital that ROIC and DCF, already covered in earlier modules, have used up to now as a general figure -- both remain intact, it's just that now you know how to precisely calculate the figure they were already using.\n\nWACC doesn't average the cost of debt and the cost of equity equally -- it weights them according to each one's relative share in the company's total financing. That weight is calculated on the same financial debt and the same equity that, already covered when building invested capital in Level 2, make up the business's complete financing. If a company finances itself 40% with debt and 60% with equity, WACC weights the cost of debt at 40% and the cost of equity at 60% -- not 50% each.\n\nFormally, WACC is the sum of two terms: the weight of debt multiplied by the after-tax cost of debt, plus the weight of equity multiplied by the cost of equity. The higher a company's proportion of debt, the more its cost -- generally lower, as already seen in this module's first lesson -- weighs in the average, and the lower the resulting WACC, up to a point: an excessively indebted company starts becoming riskier both for its lenders and its shareholders, which raises both costs separately.\n\nThe final result is a single rate, but it shouldn't be read as an exact, unquestionable figure. WACC inherits all the sensitivity of its two components -- particularly that of the cost of equity, which depends on the CAPM assumptions already covered in the previous lesson -- and adds that of the financing weights used. With this precisely calculated figure, ROIC has a more exact reference point for judging whether a company creates or destroys value, and DCF has a more precise discount rate for bringing its future flows to present value.\n\n## Example\n\nA company finances itself 30% with debt and 70% with equity. Its after-tax cost of debt is 3.75% (from the first lesson) and its cost of equity estimated with CAPM is 9% (from the second lesson). Its WACC is: 0.30 × 3.75% + 0.70 × 9% = 1.125% + 6.3% = 7.425%.\n\n## Common mistakes\n\n- Averaging the cost of debt and the cost of equity equally, without weighting by each one's real share in the company's financing.\n- Presenting the resulting WACC as an exact, definitive figure, without accounting for the fact that it inherits the sensitivity of its two components -- especially the cost of equity, sensitive to CAPM's assumptions.\n\n## Summary\n\nWACC weights the after-tax cost of debt and the cost of equity according to each one's relative share in the company's financing. It's the precise specialization of the cost of capital that ROIC and DCF already used in general terms, and it inherits the sensitivity of its two components -- it's not an exact, unquestionable figure, but a reasoned estimate.\n\n## Self-check\n\nWhy doesn't WACC average the cost of debt and the cost of equity equally?\n\nWhy shouldn't WACC be read as an exact, definitive figure?","bodyHtml":"<h2>Objectives</h2>\n<p>By the end of this lesson you understand how the cost of debt and the cost of equity are combined, weighted by the company's financing structure, to obtain the WACC.</p>\n<h2>Content</h2>\n<p>The two previous lessons developed the cost of debt and the cost of equity separately. This lesson combines them into a single figure: the WACC (Weighted Average Cost of Capital). It's the precise specialization of the cost of capital that ROIC and DCF, already covered in earlier modules, have used up to now as a general figure -- both remain intact, it's just that now you know how to precisely calculate the figure they were already using.</p>\n<p>WACC doesn't average the cost of debt and the cost of equity equally -- it weights them according to each one's relative share in the company's total financing. That weight is calculated on the same financial debt and the same equity that, already covered when building invested capital in Level 2, make up the business's complete financing. If a company finances itself 40% with debt and 60% with equity, WACC weights the cost of debt at 40% and the cost of equity at 60% -- not 50% each.</p>\n<p>Formally, WACC is the sum of two terms: the weight of debt multiplied by the after-tax cost of debt, plus the weight of equity multiplied by the cost of equity. The higher a company's proportion of debt, the more its cost -- generally lower, as already seen in this module's first lesson -- weighs in the average, and the lower the resulting WACC, up to a point: an excessively indebted company starts becoming riskier both for its lenders and its shareholders, which raises both costs separately.</p>\n<p>The final result is a single rate, but it shouldn't be read as an exact, unquestionable figure. WACC inherits all the sensitivity of its two components -- particularly that of the cost of equity, which depends on the CAPM assumptions already covered in the previous lesson -- and adds that of the financing weights used. With this precisely calculated figure, ROIC has a more exact reference point for judging whether a company creates or destroys value, and DCF has a more precise discount rate for bringing its future flows to present value.</p>\n<h2>Example</h2>\n<p>A company finances itself 30% with debt and 70% with equity. Its after-tax cost of debt is 3.75% (from the first lesson) and its cost of equity estimated with CAPM is 9% (from the second lesson). Its WACC is: 0.30 × 3.75% + 0.70 × 9% = 1.125% + 6.3% = 7.425%.</p>\n<h2>Common mistakes</h2>\n<ul><li>Averaging the cost of debt and the cost of equity equally, without weighting by each one's real share in the company's financing.</li><li>Presenting the resulting WACC as an exact, definitive figure, without accounting for the fact that it inherits the sensitivity of its two components -- especially the cost of equity, sensitive to CAPM's assumptions.</li></ul>\n<h2>Summary</h2>\n<p>WACC weights the after-tax cost of debt and the cost of equity according to each one's relative share in the company's financing. It's the precise specialization of the cost of capital that ROIC and DCF already used in general terms, and it inherits the sensitivity of its two components -- it's not an exact, unquestionable figure, but a reasoned estimate.</p>\n<h2>Self-check</h2>\n<p>Why doesn't WACC average the cost of debt and the cost of equity equally?</p>\n<p>Why shouldn't WACC be read as an exact, definitive figure?</p>","sortOrder":3,"readingMinutes":8,"difficulty":"Intermedio","url":"/en/academy/valuation/wacc-and-cost-of-capital/how-is-wacc-calculated"}],"graphSummary":{"root":{"type":"concept","id":"76","depthFromRoot":0,"entity":{"type":"concept","slug":"wacc","term":"WACC","excerpt":"Cálculo preciso del coste de capital: la media ponderada del coste de la deuda y el coste del capital propio, según el peso de cada uno en la financiación de la empresa."}},"depth":1,"returnedNodes":1,"truncated":false,"hasCycle":false,"nodes":[{"type":"concept","id":"76","depthFromRoot":0,"entity":{"type":"concept","slug":"wacc","term":"WACC","excerpt":"Cálculo preciso del coste de capital: la media ponderada del coste de la deuda y el coste del capital propio, según el peso de cada uno en la financiación de la empresa."}}],"edges":[]},"relatedNews":[],"relatedEntities":[]}