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David is CEO of New Constructs (www.newconstructs.com), an independent research that specializes in unearthing key insights from the Financial Footnotes of Annual Reports. Having analyzed over 50,000 annual reports and their Financial Footnotes, New Constructs research regularly produces Hidden... More
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  • WACC: Definition And Formula For The Weighed-Average Cost Of Capital 0 comments
    Aug 29, 2012 12:33 PM

    Weighted-Average Cost of Capital (OTC:WACC) is the average of debt and equity capital costs that all publicly traded companies with debt and equity stakeholders incur as a cost of operating. Below we provide the details behind our WACC calculations.

    Cost of Equity

    • Our cost of equity calculation is based on the Capital Asset Pricing Model methodology.
    • We use the market value of equity when calculating all Total Adjusted Market Capital ratios.
    • The Equity Risk Premium is calculated as the average of the current implied Equity Risk Premium and the historical implied Equity Risk Premium.
    • Though there are many other more complicated approaches for arriving at a firm's cost of equity, we do not feel their additional complexity offers commensurate accuracy. CAPM is simple, gets us close enough and it is easy to implement consistently across all companies we analyze.
    • For Beta, we use consistent values to avoid this variable having an inappropriately large impact on the WACC calculation. We apply industry and sector averages for beta to individual companies. Industry and sector averages are based on the actual individual company betas, which we calculate based on daily prices over the past 5 years. We assign the industry or sector averages where we see individual beta values clustered most uniformly within industries or sectors, respectively.

    Cost of Debt

    • The cost of debt capital should represent the business' long-term marginal borrowing rate.
    • The Risk-Free Rate (RFR) is approximated by the 30-year Treasury Bond. If the 30-year rate is not available, the 20-year rate is used.
    • To the RFR, we add the debt spread associated with the debt rating on the company's long-term debt.
    • The resulting pre-tax cost of debt is then multiplied by (1 - marginal tax rate).
    • We use debt ratings from Moody's or S&P.

    WACC Formula
    WACC = ( Ke ) * (E/TC) + (Kd * (1-T)) * (D/TC)+Kp * (P/TC)
    Where Ke = Cost of Equity
    E = Total Equity
    Kd = Cost of Debt
    D = Total Debt
    Kp = Cost of Preferred
    P = Preferred Capital
    E/TC = Equity Total Adjusted Market Capital Ratio
    D/TC = Debt to Total Adjusted Market Capital Ratio
    P/TC = Preferred Stock to Total Adjusted Market Capital Ratio
    T = Tax Rate

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