WACC stands for **Weighted Average Cost of Capital**, which is the weighted average of the **costs **of the different **types of capital used **by a company.

It represents the **minimum return a company must earn on its investments **to satisfy its shareholders and creditors... or let's say better that the return has to be greater than WACC, in order to really satisfy them.

Here are the steps to calculate WACC:

1️⃣ Determine the **weights of the different types of capital**: Determine the proportion of each type of capital used by the company. Here we consider two types of capital: debt and equity. The weights can be determined by the market value of each type of capital.

2️⃣ Determine the **cost of each type of capital**: the cost of debt is the interest rate paid on the company's outstanding debt.

The formula is as follows:

**Cost of Debt = (Interest Expense x (1 - Tax Rate)) / Total Debt**

where:

▪ Interest Expense is the total amount of interest paid on the company's debt over a given period

▪ Tax Rate is the company's effective tax rate, representing the percentage of pre-tax income that is paid as taxes

▪ Total Debt is the total amount of debt held by the company.

The cost of equity, on the other hand, can be calculated using the Capital Asset Pricing Model (CAPM), through which we calculate cost of equity like this:

**Cost of Equity = Risk-free Rate + Beta x (Market Risk Premium)**

where:

▪ Risk-free Rate is the rate of return on a risk-free investment such as a government bond, which represents the minimum return that investors require for taking on no risk

▪ Beta is a measure of the systematic risk of a company's equity relative to the market as a whole. A beta of 1 indicates that the stock has the same level of risk as the market, while a beta greater than 1 indicates higher risk and a beta less than 1 indicates lower risk.

▪ Market Risk Premium is the additional return that investors expect to earn for investing in the stock market as a whole, compared to a risk-free investment. It reflects the risk and volatility of the market as a whole.

3️⃣ Calculate the **weighted average cost of capital**: Multiply the weight of each type of capital by its cost and then add up the results. The formula for WACC is:

**WACC = (Weight of Debt x Cost of Debt) + (Weight of Equity x Cost of Equity)**

where:

**Weight of Debt = **Total Debt / (Total Debt + Total Equity)

**Weight of Equity = **Total Equity / (Total Debt + Total Equity)

**Cost of Debt = **Interest Rate on Outstanding Debt, Net of Tax

**Cost of Equity = **Risk-free rate + Beta * (Market Risk Premium)

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**EXAMPLE:**

Assume that ABC Company has a total debt of $4 million and equity of $6 million. The interest rate on the company's outstanding debt is 5%, the risk-free rate is 2%, the beta of the company's equity is 1.5, and the market risk premium is 6%.

The weights of debt and equity are:

**Weight of Debt = **$4 million / ($4 million + $6 million) = 0.40

**Weight of Equity = **$6 million / ($4 million + $6 million) = 0.60

The cost of debt is (net of tax) 5%, and the cost of equity is:

Cost of Equity = 2% + 1.5 * 6% = 11%

Therefore, the WACC of ABC Company is:

WACC = (0.40 x 5%) + (0.60 x 11%) = **8.6%**

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