Weighted Average Cost of Capital (WACC)

Debt is cheaper than equity for two main reasons. First, debt is senior in the capital structure, meaning that in the event of liquidation, lenders are paid before equity holders, making it lower risk. Second, interest payments on debt are tax-deductible, creating a corporate tax shield that reduces the effective cash outflow.

As a firm takes on more debt, the probability of financial distress and bankruptcy increases. This rising risk causes both lenders to demand higher interest rates (increasing the cost of debt) and equity investors to demand a higher return due to the increased financial leverage (increasing the cost of equity via a higher levered beta), eventually driving WACC upward.

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM). The formula is Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium. The risk-free rate is typically the yield on government bonds, beta measures the stock's volatility relative to the market, and the equity risk premium is the excess return investors expect over risk-free assets.

The tax shield refers to the reduction in taxable income that results from the tax-deductibility of interest expenses. Because a company pays less corporate tax when it has debt, the net cost of borrowing is lowered. This directly reduces the debt component of the WACC equation, lowering the overall blended cost of capital.

You must always use market value weights for both equity and debt when calculating WACC. This is because WACC is designed to measure the current opportunity cost of raising an incremental unit of capital at today's market rates, rather than historical accounting values recorded on the balance sheet.

An increase in the risk-free rate drives up both the cost of equity (via CAPM) and the cost of debt (as broader borrowing costs rise across the economy), thereby increasing the overall WACC.

The Equity Risk Premium is the excess return that investors demand for holding equities over risk-free assets like government bonds, typically ranging from 4% to 6% in developed markets.

If public bond yields are unavailable, you can look at the interest rates on the company's recent bank loans, or estimate a synthetic credit rating based on its financial ratios and apply the corresponding credit spread.

An increase in the corporate tax rate increases the value of the tax shield, which lowers the after-tax cost of debt. Assuming all other factors remain constant, this will cause the overall WACC to decrease.

Unlevered Free Cash Flows represent the cash available to all investors (both debt and equity holders) before interest is paid. Therefore, they must be discounted using a rate that reflects the blended cost of both capital sources.

Yes, WACC fluctuates constantly due to changes in macroeconomic variables like interest rates, market volatility affecting beta, shifts in company capital structure, and adjustments to tax legislation.

WACC and Enterprise Value are inversely related. Because WACC is the denominator in the DCF valuation equation, a lower WACC increases the present value of future cash flows, resulting in a higher Enterprise Value.