Understanding WACC: A Student
Guide
A Comprehensive Teaser for Finance Students
Instructor: [Your Name]
Course: Introduction to Finance Date: May 04, 2025
Designed for classroom teaching and practice
Trang 22 Components of WACC 2
3 Calculating WACC 3
4 Applications of WACC 5
5 Tips and Common Mistakes 7
Trang 3WACC Teaser For Classroom Use
1 Introduction to WACC
The Weighted Average Cost of Capital (WACC) is a key concept in finance, representing the average cost a company pays to finance its operations using debt (e.g., bank loans) and equity (e.g., owner’s investment or shareholders’ funds) Think of WACC as the “price” of money a business uses, expressed
as a percentage It’s essential for:
• Valuing a company by discounting future cash flows
• Evaluating projects (e.g., opening a new store) to see if they’re worth the cost
• Understanding how companies balance debt and equity to minimize financing costs
This teaser explains WACC’s components, formula, and applications through simple examples, such as small businesses like a lemonade stand, bakery, or coffee shop You’ll learn how to calculate WACC and use it to make financial decisions
1 What is WACC?
WACC is the weighted average of the cost of debt and the cost of equity, based on how much
of each a company uses Debt is cheaper because interest payments are tax-deductible, while equity is more expensive because investors expect higher returns for taking on more risk
Why WACC Matters:
• It’s the “hurdle rate” for investments: Projects must earn more than WACC to create value
• It helps estimate a company’s value by discounting future cash flows at the WACC rate
Real-World Example: Imagine a lemonade stand financed with a $5,000 bank loan (debt) and
$15,000 from the owner (equity) WACC tells us the average cost of this $20,000, helping decide
if a new cart is a good investment
2 Components of WACC
WACC combines two main costs: the cost of debt and the cost of equity Each is weighted by its proportion in the company’s total capital, using market values (not book values, as emphasized in the
‘wacc.pdf‘ document, page 18)
Trang 42 Cost of Debt
The cost of debt is the interest rate a company pays on borrowed money, adjusted for taxes because interest is tax-deductible It’s typically lower than the cost of equity because lenders face less risk than investors
Formula:
Cost of Debt = R d × (1 − T )
Where:
• R d= Interest rate on debt (e.g., 6%)
• T = Tax rate (e.g., 20%).
Example: A bakery takes a $10,000 loan at 5% interest, with a 25% tax rate.
Cost of Debt = 0.05 × (1 − 0.25) = 0.05 × 0.75 = 0.0375 or 3.75%
The after-tax cost of the loan is 3.75%
Excel Grid:
4 After-Tax
B4: = B2 * (1 - B3) returns 3.75%
3 Cost of Equity
The cost of equity is the return expected by owners or shareholders for investing in the company It’s higher than the cost of debt because equity investors take on more risk (e.g., they’re paid after lenders if the company fails)
For simplicity, we’ll assume the cost of equity is an expected return set by investors (The
‘wacc.pdf‘ document, pages 11–13, uses CAPM, but we’ll avoid that complexity here.)
Example: The bakery’s owner invests $20,000 and expects a 12% return because the business
is riskier than a bank loan
Excel Grid:
Investment $20,000
3 Calculating WACC
Trang 5WACC Teaser For Classroom Use
4 WACC Formula
The WACC formula is:
WACC =
(
D
D + E × R d × (1 − T )
) +
(
E
D + E × R e
)
Where:
• D = Market value of debt.
• E = Market value of equity.
• R d= Cost of debt (interest rate)
• R e = Cost of equity (expected return)
• T = Tax rate.
Simple Explanation:
D+E = Percentage of total capital from debt
D+E = Percentage of total capital from equity
• R d × (1 − T ) = After-tax cost of debt.
5 Example 1: Lemonade Stand
Let’s calculate WACC for a lemonade stand:
• Debt: $5,000 loan at 6% interest (R d = 0.06).
• Equity: $15,000 from the owner, expecting 10% return (R e = 0.10).
• Tax Rate: 20% (T = 0.20).
• Total Capital: $5,000 + $15,000 = $20,000.
Step 1: Calculate Weights
• Debt weight: D
D+E = 20,000 5,000 = 0.25 (25%).
• Equity weight: E
D+E = 15,000 20,000 = 0.75 (75%).
Step 2: Adjust Cost of Debt
R d × (1 − T ) = 0.06 × (1 − 0.20) = 0.048 or 4.8%
Step 3: Calculate WACC
WACC = (0.25 × 0.048) + (0.75 × 0.10) = 0.012 + 0.075 = 0.087 or 8.7%
Excel Grid:
D4: = (B2/B4 * C2) + (B3/B4 * C3) returns 8.7%
Trang 66 Example 2: Bakery
Now, let’s try a bakery:
• Debt: $10,000 loan at 5% interest (R d = 0.05).
• Equity: $20,000 from the owner, expecting 12% return (R e = 0.12).
• Tax Rate: 25% (T = 0.25).
• Total Capital: $10,000 + $20,000 = $30,000.
Step 1: Calculate Weights
• Debt weight: 10,000
30,000 = 0.333 (33.3%).
• Equity weight: 20,000 30,000 = 0.667 (66.7%).
Step 2: Adjust Cost of Debt
0.05 × (1 − 0.25) = 0.0375 or 3.75%
Step 3: Calculate WACC
WACC = (0.333 × 0.0375) + (0.667 × 0.12) = 0.0125 + 0.08 = 0.0925 or 9.25%
Excel Grid:
D4: = (B2/B4 * C2) + (B3/B4 * C3) returns 9.25%
7 Example 3: Coffee Shop
For a coffee shop:
• Debt: $15,000 loan at 7% interest (R d = 0.07).
• Equity: $25,000 from investors, expecting 15% return (R e = 0.15).
• Tax Rate: 30% (T = 0.30).
• Total Capital: $15,000 + $25,000 = $40,000.
Step 1: Calculate Weights
• Debt weight: 15,000
40,000 = 0.375 (37.5%).
• Equity weight: 25,000 40,000 = 0.625 (62.5%).
Step 2: Adjust Cost of Debt
0.07 × (1 − 0.30) = 0.049 or 4.9%
Step 3: Calculate WACC
WACC = (0.375 × 0.049) + (0.625 × 0.15) = 0.018375 + 0.09375 = 0.112125 or 11.21%
Trang 7WACC Teaser For Classroom Use
8 Project Evaluation
WACC is the “hurdle rate” for projects If a project’s expected return exceeds WACC, it creates value; if it’s below WACC, it destroys value
Example: The bakery (WACC = 9.25%) considers a new oven costing $12,000, expected to
generate $1,500 per year The return is:
1, 500
12, 000 = 0.125 or 12.5%
Since 12.5% > 9.25%, the oven is a good investment
Excel Grid:
2 Project Cost $12,000
B4: = B3 / B2 returns 12.5%
9 Company Valuation
WACC is used to discount a company’s future cash flows to estimate its enterprise value (EV),
as noted in the ‘wacc.pdf‘ document (page 18)
Example: The coffee shop (WACC = 11.21%) expects $5,000 in annual cash flows for 5 years.
The present value (simplified) is calculated using WACC as the discount rate For simplicity, assume a single cash flow:
PV = Cash Flow
1 + WACC =
5, 000
1 + 0.1121 =
5, 000 1.1121 ≈ $4, 496
This helps estimate the shop’s value
Excel Grid:
4 Present Value $4,496
B4: = B2 / (1 + B3) returns $4,496
Trang 85 Tips and Common Mistakes
10 Best Practices and Pitfalls
To calculate WACC accurately:
• Use Market Values: Always use market values for debt and equity, not book values
(per ‘wacc.pdf‘, page 18) For small businesses, use the actual loan amount and estimated equity value
• Include Tax Shield: Adjust the cost of debt for taxes, as interest is deductible.
• Verify Inputs: Ensure interest rates, expected returns, and tax rates are realistic.
Common Mistakes:
• Using book values instead of market values for weights
• Forgetting the tax adjustment for debt (e.g., using 6% instead of 4.8% after tax)
• Miscalculating weights (e.g., dividing by debt instead of total capital)
Example Mistake: For the lemonade stand, using a pre-tax cost of debt (6%) instead of 4.8%
would inflate WACC:
Wrong WACC = (0.25 × 0.06) + (0.75 × 0.10) = 0.015 + 0.075 = 0.09 or 9%
This overstates the cost by 0.3%
Excel Grid: