In a recent Hirevue interview, JPMorgan’s New York office asked this question:

“How do you calculate a company’s WACC?”

### What is WACC?

WACC stands for Weighted Average Cost of Capital, a concept that often gets tested on during investment banking interviews.

It’s one of the most important assumptions you make when you’re doing a DCF or discounted cash flow analysis. In other words, a small change in your WACC can have a very large impact on the valuation of the company.

### Calculating DCF

Before knowing how to calculate WACC, you have to know what a “DCF” or discounted cash flow is. As a review, **DCF is just a way to figure out how much a business is worth.** By taking all of its future cash flows, and discounting it back to its present value, or how much it would be worth today.

**Example 1**

- If I offered to give you $100 today, or $100 a year from now, you would rather have $100 today. This is because you can then invest the $100 you get today, so that 1 year from now you have more than $100.
- Similarly, if I offered you $100 a year from now, or $100 two years from now, you would rather have the $100 a year from now. Because you’ll be able to take that money, invest it for a year, and have more than $100 two years from now.

To figure out how much your $100 today would be worth a year from now, we need to know what is the expected return you would get if you were to invest that money today.

If I were a really conservative investor and wanted to invest it in something really safe like treasury bills (which is basically loaning money to the government to earn an interest), I might get something around 4%, depending on what the current interest rate environment looks like.

That means if I got $100 today, I would be able to turn that into $104 a year from now. So unless you are willing to give me $104 or more a year from today, then I’d rather have $100 today.

Or, if you can only give me $100 a year from now, then that would only be worth $96.15 to me today because I can take $96.15 today and earn a 4% return on it to get to $100 a year from now.

**Example 2**

- Let’s pretend I’m feeling a bit more adventurous or had a slightly higher risk tolerance: I decide to invest my money into the stock market instead of just loaning it to the government.

In this scenario, I might say the expected return is about 10% because that’s what the long term historical average has been for the S&P500. In this case, I can turn $100 today into $110 a year from now.

Unless you are willing to give me $110 or more a year from today, I’d rather have $100 today. Alternatively, if you can only give me $100 a year from now, that would only be worth $90.91 to me today, because I can take $90.91 today and earn a 10% return on it to get to $100 a year from now.

So what did you notice just now?

If my expected return increased from 4% to 10%, then the value of $100 a year from now actually decreased from just over $96 to a little less than $91. In other words, the value of that future cash flow is now worth less today.

The same thing happens when you’re doing a DCF.

**The WACC is the return that the company’s investors would expect to get by investing their money into the business.**

If their expected returns are higher, then the company is going to be worth less today, meaning that the price they’re willing to pay for the company’s shares is also lower. Alternatively, if their expected returns are lower, then the company is going to be worth more today, which means the price they’re willing to pay for the company’s shares is also higher.

If I can pay less upfront when I’m investing, then all else equal I should get a higher return in the end because it was cheaper for me to buy in.

Generally speaking, there’s a rule in investing that says “High risk, high returns. Low risk, low returns.” This means that if an investment is considered to be riskier, investors will demand or expect a higher return to compensate them for taking on the additional risk.

Similarly, if an investment is considered to be safer, the investors will demand or expect a lower return.

This is why if you loan your money to the United States government, you might only earn 4% or less. Because the US government is seen as the safest entity in the world for you to be loaning your money to, because in theory it will never default. If the government couldn’t pay you back, it can always just print more money.

Conversely, if you invest in the stock market, there is a chance that the stocks you buy will go down, and you might not get all of your money back. There has to be a higher expected return in the stock market, or else nobody would ever invest in stocks and everyone would just loan their money to the government instead.

### The WACC formula and how it’s calculated

WACC formula:

WACC = Wd x Rd x (1 – t) + Wp x Rp + We x Re

This formula can be split up into three parts:

1) **Wd x Rd x (1 – t)**, which represents the *debt holders*, represented by the small “d”

These are investors who loaned the company money. If the company didn’t borrow any money and therefore has no debt, then this part of the formula is irrelevant and just becomes 0.

2) **Wp x Rp**, which represents the *preferred shareholders*, represented by the small “p”

These are investors who invested in the company’s preferred shares. Not all companies have preferred shares. If there are no preferred shares then this part of the formula is also irrelevant and just becomes 0.

3) **We x Re**, which represents the *equity holders*, represented by the small “e”.

These are investors who invested in the company’s common shares. In other words, they bought a % ownership in the business.

Now within each of these three parts, the “W” in the formula represents the weighting.

- For example, if a company raised $1,000,000 of capital in total from its investors and $200,000 of that is in the form of debt, this means
**Wd**would be 20% because 20% of the capital structure is debt. - The company did not sell any preferred shares, so
**Wp**is 0%. - This means the remaining $800,000 was raised in the form of equity. So
**We**would be 80% because 80% of the capital structure is equity.

Next, let’s look at the “R” in the formula, which represents the return that each type of investors are expecting from investing in this business.

- We refer
**Rd**to the “cost of debt.”

Let’s say the debt holders are loaning the company money at a 5% interest rate. This means that in addition to paying back the amount that was borrowed, the company also has to pay 5% of the balance owed each year.

So the cost of debt is 5%.

**Rp**or the “cost of preferred,” this is irrelevant in our example because the company doesn’t have any preferred shares.

But if the company did have preferred shares, the cost of preferred would be the dividend yield. For example, if each preferred share cost $10 to purchase, and the dividend was $1, then the dividend yield would be 10%.

But again for our example, let’s assume it’s 0.

**Re**or “cost of equity” is the return that equity investors expect to get for buying a % ownership in the business.

The cost of equity is calculated by using the CAPM, which stands for “*capital asset pricing model.*” But for now just know that the cost of equity is always higher than the cost of debt.

So if the cost of debt for the business is 5%, let’s assume the cost of equity is 15% for now.

Why is the cost of equity always higher than the cost of debt?

In the world of finance, investing in a company’s debt is always less risky than investing in the company’s equity. This is because if anything goes wrong and the company is going to go bankrupt, the law demands that debt holders get paid back first before equity holders.

In those instances, the debt holders will usually get to recover at least some of the money they loaned until the company is completely out of money.

Whereas the equity holders will get nothing, so their investment becomes worthless. For these reasons, equity holders will always expect higher returns than debt holders, to compensate them for the additional risk they’re taking on.

- The last missing part of the calculation is
**t**, the company’s tax rate.

This is because the interest expense on any debt borrowed is tax deductible according to the government.

Let’s say the company’s tax rate is 20%. Even though the cost of debt is 5%, we essentially get 20% of the 5% reimbursed to us because we can pay less taxes.

That’s why we multiply the cost of debt by (1-t), and if t is 20% then (1-t) is 80%.

Now with all of the assumptions, we can see that the WACC for this company is: WACC = 20% x 5% x 80% + 0% x 0 + 80% x 15% = 12.8%

In other words, on a weighted average basis, the company’s investors expect a 12.8% return on their investment when they invested into the business. So all of the company’s future cash flows have to be discounted by 12.8% to get back to what the company should be worth today.

At this point, you should have a high level understanding of how the weighted average cost of capital works. The next time you get asked this question in an interview, hopefully you’ll ace it.

If you would like more hands-on and personalized coaching with your investment banking or private equity interviews from our team of coaches that includes the former global heads of recruiting at top investment banks like Goldman Sachs, Credit Suisse, UBS, and Lehman Brothers, then please don’t hesitate to reach out to our team.

And as always – remember – nothing worthwhile comes easy, and nothing is more important than your future.

Keep Grinding!

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