WACC formula and calculator

Enter the market value of the equity, the market value of the debt, what each of them costs, and the tax rate the company pays. The calculator returns WACC, the weight of each source of capital, and the cost of debt once the tax relief on interest is counted.

WACC is the rate a company discounts its own future cash flows at. It is the number that goes into a net present value, and it is the bar an internal rate of return has to clear. A rate that is half a point too low raises every present value in a long forecast, so the projects it wrongly accepts are the marginal ones that were closest to the line already.

What comes out is a nominal rate. A lender quotes a nominal rate, and the risk-free rate inside the cost of equity is a nominal government yield, so WACC carries inflation in it and belongs against cash flows that carry inflation too. Discount a forecast written in today's prices at a nominal WACC and inflation gets counted twice, which understates the project by more the longer the forecast runs. Either inflate the cash flows or strip the inflation out of the rate, but do not mix the two.

The answer is only as good as the two costs going in, and neither is printed on a statement. The cost of debt is what the company would pay to borrow today, not the coupon on borrowing it did years ago. The cost of equity is an estimate of what shareholders require, and reasonable people put it in a range rather than on a point.

$$\text{WACC} = \frac{E}{V} \times R_e + \frac{D}{V} \times R_d \times (1 - t)$$

Since $V = E + D$, the two weights add to 1, so WACC lands between the cost of equity and the after-tax cost of debt. Move a dollar of funding from one side to the other and the answer slides along the line between those two costs.

Two sources is the usual case rather than the only one. Where a company has preferred stock the formula grows a third term, $\frac{P}{V} \times R_p$, with $V$ widened to $E + P + D$ and no $(1 - t)$ against it, because preferred dividends are paid out of taxed profit like ordinary ones. That also lifts the bound above: with a third source priced higher than the cost of equity, WACC can land above the cost of equity rather than between the two costs. This calculator runs the two-source case, so preferred stock has to be added by hand.

Use market values, not the balance sheet. Equity at market value is the share count times the share price. Debt at market value is what its bonds fetch, and where the debt is not traded its book value is a fair stand-in, because a loan at a rate near today's rate is worth close to what is owed. Book equity is not a stand-in for market equity, and the common mistake below shows what happens when it is used as one.

The cost of equity is usually estimated with the capital asset pricing model: the risk-free rate, plus beta times the equity risk premium. The cost of debt is the yield the company's debt carries now.

A company with no debt has an equity weight of 1, and its WACC is its cost of equity. That is a useful check on the arithmetic: set the debt to zero in the calculator and the two figures should agree.

Interest counts as a cost of doing business wherever the tax code says it does, so a company that pays interest usually pays less tax. That is why the debt term carries $(1 - t)$ and the equity term does not. Dividends and buybacks come out of profit that has already been taxed, so there is nothing to deduct.

At a 25 percent tax rate, every dollar of interest costs the company 75 cents once the deduction is counted, which turns a 5 percent coupon into a 3.75 percent cost. What the relief is worth to WACC is the debt weight times the cost of debt times the tax rate: 0.5 percentage points on the figures in the first worked example, and more at every higher tax rate, debt weight or borrowing cost. The second worked example is the one that measures that gap, by switching the relief off and running the same company again.

Three conditions sit behind that, and any of them can take it away.

• There has to be taxable profit to shelter. A company making losses deducts nothing this year, though many tax systems let the deduction be carried forward to a year when there is profit again.
• The deduction has to be allowed. In the United States, interest on business borrowing is generally deductible against taxable income, subject to a cap tied to earnings that has been rewritten more than once. Other countries set their own caps, deny relief on some structures, or give equity a matching allowance so the bias disappears. Check the rule that applies to the company and the year rather than carrying one country's treatment into another.
• The rate has to be the marginal one. The figure that matters is the rate on the profit the interest actually shelters, not the average rate that falls out of last year's accounts.

Where interest is not deductible, or there is no profit to shelter, set the tax rate to 0. The debt term then costs its full amount, which is exactly what the second worked example runs.

Debt costs less than equity almost everywhere you look, for two sound reasons. Lenders are paid before shareholders and can force the issue if they are not, so they carry less risk and ask for less return. The deduction then takes a further slice off what the company pays.

So tilting the mix towards debt lowers WACC, which is what the third worked example shows: the same company funded 60 percent by debt rather than 40 percent reads 5.85 percent instead of 6.9 percent.

That calculation holds both input costs fixed, and holding them fixed is the trick in it. Every extra dollar borrowed puts a fixed claim ahead of the shareholders and makes what is left of the profit swing harder, so the cost of equity rises with the leverage ratio. Lenders watching their cover thin out want more as well, and past a point they want covenants and security on top of the higher rate. Both inputs climb while the weights move towards the cheaper one, and the two effects pull against each other.

The classic result, from Modigliani and Miller, is that with no taxes and no cost of financial distress the two cancel exactly: the cost of equity rises by just enough to leave WACC where it was, and how a firm is funded says nothing about what it is worth. Add the tax deduction and borrowing wins for a while. Add the cost of distress, where a forced sale, a rushed refinancing or a covenant breach starts to look possible, and it stops winning, because that risk prices into the debt and the equity at the same time. Firms in the same industry clustering around a similar mix, rather than borrowing to the limit, is that trade-off showing up in practice. Judging where the limit sits is a risk and return question, and it cannot be settled by pointing at the lower number.