How to Calculate the Weighted Average Cost of Capital for Investment Banking
In investment banking, the weighted average cost of capital (WACC) is a very important input into the discounted cash flow models. It's defined as the average rate of return of a company's suppliers of capital, and it's the rate at which the future cash flows of the firm are discounted back to a present value for valuation purposes.
All else equal, the higher the WACC, the lower the value of the firm. That's because the cost of capital is higher for riskier firms.
IBM can access capital much more inexpensively than can an unproven, startup firm. And investing in IBM is much less risky than investing in an unproven startup firm. One thing that market participants agree on is that to induce investors to make riskier investments, they must expect higher returns.
The formula for WACC is simple: It's a weighted average. The individual component costs of the different types of capital (stocks and bonds) are weighted by the percentage of stocks and bonds in the capital structure (how the firm is financed — the percentage of financing that has come from stock and the percentage that has come from bonds). So, the WACC formula is simply
where D is the value of debt, E is the value of equity, rd is the required return on debt, and re is the required return on equity.
So, if you have a company that is financed with one-third debt and two-thirds equity, and the after-tax required return on debt is 5 percent, and the required return on equity is 10 percent, the WACC for the firm is:
When apply the discounted cash flow models for this firm, you would discount all the future cash flows at an 8.34 percent annual rate.
One of the first variations that you see in determining the WACC is that some investment banking analysts use current market value weights when calculating the WACC, while other analysts use target weights. Current market value weights are simply the current weights observed in the capital structure. Target weights incorporate the analyst's expectations about the capital structure he believes the company will likely use over the foreseeable future.