Wacc Formula Essay

1140 Words5 Pages
A1 of 3 Formulas involved on the WACC calculations Corporate Finance - MBA 2009 Note written by Prof. Carles Vergara-Alert & Prof. Pedro Saffi 1 Objective This note tries to clarify the different assumptions and formulas used to calculate the Weighted Average Cost Of Capital (WACC) that you will find in different textbooks and articles. 2 The WACC formula The WACC formula is a weigthed average of the cost of equity and the after-tax cost of debt: W ACC = E D+E RE + D D+E (1 − τ )RD (1) being RE the cost of equity, RD the cost of debt, τ the corporate tax, E the market value of the firm’s equity, and D the market value of the firm’s debt. Note that sometimes we call V to the sum of D and E, therefore, V = D + E. Sometimes, not all the financing is provided by debt and equity. As an example, let us assume that some financing is provided by preferred stock as well as equity and debt. The WACC formula has to be modified to include the main sources of long-term financing of the firm such as preferred stock: W ACC = E D P RE + (1 − τ )RD + RP D+E+P D+E+P D+E+P where RP is the cost of preferred stock and P is the market value of the firm’s preferred stock. 3 Using the WACC formula It is straightforward to obtain most of the values for the variables in the WACC formula (let’s focus on formula (1) from now on): • The market value of the firm’s equity (E) can be simply estimated as the value of the firm’s shares times the number of shares. • The book value of the firm’s debt can be used as a proxy for the market value of the firm’s debt (D). • The corporate tax rate is given (ex. τ = 34% can be used as a proxy for federal tax rate in the US). • The cost of debt RD should reflect the reality of the company. Each company knows its debt rate premium that they will have to pay for their debt, that is, it knows the spread over the treasury that lenders will require to lend

More about Wacc Formula Essay

Open Document