# How does a WACC Calculator work?

*by Jason Varner Financial Projections Template*

Weighted Average Cost of Capital (WACC) calculates a firm's cost of capital in which each category of capital is proportionately weighted. These costs vary depending on the risk level of the firm. More specifically, the riskier the firm, the higher the cost of capital, and the less risky the firm is, the lower the capital.

Debt Equity Mix is the targeted relationship between debt and equity financing. It should be analyzed using the debt capacity of the company. By looking at the debt ratio, the analyst will determine the extent of the company's leverage. Banks tend to finance a company's operation if its EBITDA is three times the debt; this means that the company would be able to pay their debt within three years. While if the debt structure is more than four, it will be too risky for the bank, and it also means that the company is riskier compared to similar industries in the market.

The Cost of Equity refers to the required return by shareholders for the risk they take from their investment. Determine the cost of equity using the Capital Asset Pricing Model (CAPM), which attempts to estimate the expected return on a security based on its risk level.

• Unlevered Beta measures the risk of the company without considering its debt structure.

• Levered Beta takes the debt and equity in its capital structure and measures its risk to market volatility.

• Market Risk Premium refers to the premium an investor requires to invest in stock rather than in a fully secure government bond with zero risks.

• Risk-Free Interest is the minimum return an investor expects to earn without risk like a US bond.

• Country Spread is the adjustment factor as per the country risk premium of the target company. In reality, not all countries have zero risks, and some have minimal risk.

• Equity Risk Premium is the measure of how individual security will outperform risk-free debt instruments.

• Other premium is a small-cap premium or key man premium, which means the risk from other potential problems that may occur in the future.

Cost of Equity is derived by the summation of Equity Risk Premium, Risk-Free Rate, and Other premium. Which means that the cost of equity should cover all the risk involved in the stock market. A company should be able to convince its investors to take a chance on them; hence, their cost of equity shall exceed the investor's return from investing in the risk-free securities.

The Cost of Debt refers to the effective interest rate the company expects to pay its debt holders or creditors. As compared to cost of equity, cost of debt is less complicated and does not require complex calculations. It is the actual interest rate from borrowing or financing. However, always remember to account for the tax savings taken advantage through interest payments; hence it's a tax-deductible.

Determine the cost of debt by multiplying the actual interest rate by the after-tax rate using the WACC calculator. Notice that the pre-tax cost of debt is derived by the summation of the risk-free rate and debt risk premium. The debt risk premium is the difference of risk-free interest over the effective interest rate paid by the company.

After determining the cost of debt and cost of equity, the rest is pure mathematics. Just multiply the cost of capital by the weighing factor or the capital structure.

The higher the cost of capital, the higher the risk. The company should generate earnings higher than the cost of capital to pay the financing providers such as banks and shareholders. WACC indicates the minimum return a company should make to satisfy its creditors and stakeholders. It's called a weighted average because it gives more weight or importance to either borrowed capital or investors' money, whichever is greater.

**Deciding on the Target Debt-Equity Mix**Debt Equity Mix is the targeted relationship between debt and equity financing. It should be analyzed using the debt capacity of the company. By looking at the debt ratio, the analyst will determine the extent of the company's leverage. Banks tend to finance a company's operation if its EBITDA is three times the debt; this means that the company would be able to pay their debt within three years. While if the debt structure is more than four, it will be too risky for the bank, and it also means that the company is riskier compared to similar industries in the market.

**How to Determine Cost of Equity?**The Cost of Equity refers to the required return by shareholders for the risk they take from their investment. Determine the cost of equity using the Capital Asset Pricing Model (CAPM), which attempts to estimate the expected return on a security based on its risk level.

**Using the WACC calculator, calculate the cost of equity systematically.****Definition of Terms**• Unlevered Beta measures the risk of the company without considering its debt structure.

• Levered Beta takes the debt and equity in its capital structure and measures its risk to market volatility.

• Market Risk Premium refers to the premium an investor requires to invest in stock rather than in a fully secure government bond with zero risks.

• Risk-Free Interest is the minimum return an investor expects to earn without risk like a US bond.

• Country Spread is the adjustment factor as per the country risk premium of the target company. In reality, not all countries have zero risks, and some have minimal risk.

• Equity Risk Premium is the measure of how individual security will outperform risk-free debt instruments.

• Other premium is a small-cap premium or key man premium, which means the risk from other potential problems that may occur in the future.

Cost of Equity is derived by the summation of Equity Risk Premium, Risk-Free Rate, and Other premium. Which means that the cost of equity should cover all the risk involved in the stock market. A company should be able to convince its investors to take a chance on them; hence, their cost of equity shall exceed the investor's return from investing in the risk-free securities.

**Calculation of the Cost of Debt**The Cost of Debt refers to the effective interest rate the company expects to pay its debt holders or creditors. As compared to cost of equity, cost of debt is less complicated and does not require complex calculations. It is the actual interest rate from borrowing or financing. However, always remember to account for the tax savings taken advantage through interest payments; hence it's a tax-deductible.

Determine the cost of debt by multiplying the actual interest rate by the after-tax rate using the WACC calculator. Notice that the pre-tax cost of debt is derived by the summation of the risk-free rate and debt risk premium. The debt risk premium is the difference of risk-free interest over the effective interest rate paid by the company.

After determining the cost of debt and cost of equity, the rest is pure mathematics. Just multiply the cost of capital by the weighing factor or the capital structure.

**Conclusion: WACC is a Weighted Average Cost of Financing**The higher the cost of capital, the higher the risk. The company should generate earnings higher than the cost of capital to pay the financing providers such as banks and shareholders. WACC indicates the minimum return a company should make to satisfy its creditors and stakeholders. It's called a weighted average because it gives more weight or importance to either borrowed capital or investors' money, whichever is greater.

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Created on Jul 6th 2020 06:37. Viewed 152 times.

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