The   weighted average cost of capital (WACC) is a type of discount rate that incorporates return to all portions of a subject investment’s capital structure.  Two components of the WACC calculation are a firm’s cost of equity capital and the firm’s cost of debt.  The WACC is often referred to as a firm’s “cost of capital.”

For business valuations estimating fair market value, the discount rate is a market-driven rate.  It represents the expected yield rate – or rate of return – necessary to induce investors to commit available funds to the subject investment, given its level of risk.

Components of the cost of equity capital:

• The risk-free rate (Rf) – the return that an investor feels certain of realizing over the holding period.  This is typically based on long-term US treasury bonds.
• The equity risk premium (ERP) – the additional return (above the risk-free rate) required for investors to hold equity investments.  This is typically based on the average annual return of the S&P 500 in excess of long-term government bonds from 1926 to the present.
• The unsystematic risk premium (USRP) – risk associated with unique circumstances and factors for a specific investment.

Equity Risk Premium Example: Stock Returns in Excess of Government Bonds

One method by which a firm’s cost of equity is estimated is known as the capital asset pricing model (CAPM).  CAPM is part of a larger body of economic theory known as capital market theory, which also includes portfolio management theory, that describes how investors should behave in selecting common stocks for their portfolio, under a given set of assumptions.  CAPM describes the market relationships that will result if investors behave in the manner prescribed by portfolio theory.

Systematic risk, a measure of risk that affects all businesses, is measured in CAPM by a factor called beta (β).  Beta is a function of the relationship between the return of an individual security and the return on the market as measured by a broad index (usually the S&P 500).  A security with a beta of 1.0 tends to move up or down in direct correlation with the market.  Securities with a beta greater than 1.0 tend to rise and fall by a greater percentage than the market.  A beta of less than 1.0 suggests the security is less sensitive to changes in the market.

The cost of equity (Ke) calculation is as follows:

Ke  =  Rf + ( β x ERP ) + USRP

The WACC calculation is a function of the cost of capital components and the capital structure of the firm and its industry.  The formula used for the calculation of the WACC is presented below:

WACC  =  ( We x Ke ) + ( Wd x Kd ) x ( 1 – Tm )

Where:

We    =    the proportion of equity in the capital structure
Ke    =    the cost of equity
Wd    =    the proportion of debt in the capital structure
Kd    =    the pretax cost of debt
Tm    =    the effective tax rate for the subject company

The correct calculation of a WACC is of utmost importance in performing a robust and supportable business valuation.  ValueScope is equipped with the knowledge and tools to perform and support all facets of your business appraisal needs.