To calculate the WACC you need the cost of equity, cost of debt, the proportions of equity and debt in the total value of the company, and the corporate tax rate.
But what if you’re given the debt-to-equity ratio only, instead of the value of equity, the value of debt, and the total capital structure?
There are two quick ways to solve this, which I will teach you in this post.
Ready? Let’s dive in:
First, let’s briefly go through what is the WACC.
The Weighted Average Cost of Capital (WACC) tells you the return a company pays for the equity and debt capital that finance its assets, in proportion to each source of capital. In other words, it’s the average after-tax total cost of capital.
It expresses in a single number the return that shareholders and lenders require to provide the company with capital.
Generally, a low WACC indicates a healthy mature safe business able to attract investors at a lower cost due to the low risk. Lots of debt will also reduce the total cost of capital (up to a certain point).
On the other hand, a higher WACC is typical in riskier businesses or startups just beginning their journey. In these cases, investors are taking on bigger risks and thus want to be compensated with higher returns.
Analysts use the WACC as the discount rate for future cash flows in discounted cash flow analysis to estimate the fair value of a business or project.
Here’s how you calculate the WACC:
How to Calculate the WACC
The WACC formula is the following:
- rE is the cost of equity. This is the rate of return equity investors require for funding the company. Analysts usually compare it to the return on equity to assess if the company is creating shareholder value. It varies according to the risk and volatility of the business and is generally calculated using the capital asset pricing model.
- E is the total market value of equity. It is not necessarily the shareholder’s equity you find on the balance sheet.
- V is the total value of the company (of its assets). It is equal to the sum of Equity + Debt.
- rD is the cost of debt. Or the average return banks and bondholders receive for lending money to the company. The better the firm’s credit rating, the lower the cost of debt. Also, the cost of debt is typically lower than the cost of equity, as debt is safer than equity.
- D is the market value of debt. More specifically financial debt. Not all liabilities from the balance sheet are included here.
- t is the corporate tax rate. Businesses can deduct interest expenses from their taxes. As a result, to get the net cost of debt, you need to subtract the tax benefits from the interest payments.
Now, how can you calculate the weighted average cost of capital if you don’t have Equity, Debt, and total Value, but you have the debt-to-equity ratio?
How to Calculate WACC with Debt to Equity Ratio Only
Before we dive in, let’s briefly remember what is the debt-to-equity ratio:
The debt-to-equity ratio, as the name implies, compares the proportion of a company’s debt to its equity.
This is useful to determine if a company is overleveraged, and how much it relies on debt financing. It varies significantly from industry to industry.
A higher D/E ratio suggests more risk, as it indicates the business may have a harder time meeting its financial obligations.
When the D/E ratio is negative it means the company’s total debts exceed its shareholder equity, resulting in a negative net worth. This is bad.
Now, here are two ways to calculate the WACC using the D/E ratio:
#1) Extrapolate from the Fraction Version of D/E
When you’re given the D/E ratio as a percentage, you can transform that into numbers to make it easier to visualize and extrapolate the value of the company, of its equity, and of its debt.
Say the D/E of a company is 40%.
You can turn that into a fraction containing absolute numbers and say the D/E is 4/10.
Now, this means debt is 4 and equity is 10. As to the value?
It’s the sum of debt and equity. In this case 4+10=14.
Now you can resume computing the WACC. Multiply the cost of equity by 10/14 and multiply the net cost of debt by 4/14.
Makes sense, right?
There’s also an alternative WACC formula that uses the D/E ratio as opposed to equity and debt vs. the total company value:
#2) Equivalent WACC Formula using D/E
Here’s the equivalent WACC formula using the D/E as opposed to the total value of the company:
Now let’s go through a quick example to put these concepts in motion and make sure all three ways of computing the WACC are equal:
WACC using D/E Example
Consider a company with the following characteristics:
|Cost of Equity||5%|
|Cost of Debt||3%|
|Corporate Tax Rate||20%|
Let’s compute the WACC in the three different ways we saw above.
First, using the “normal” WACC formula you get a cost of capital of 3.84%:
Now let’s say you weren’t given the values for equity and debt. Instead, all you knew was that the debt-to-equity ratio is 80%. How do you calculate the WACC?
You can decompose the 80% into a fraction such as 8/10 and assume debt is 8 and equity is 10. This means the total value of the company is 8+10=18. You’ll get the same WACC of 3.84%:
Lastly, you can use the alternative WACC formula that needs the D/E ratio only:
Works like magic.
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