EBS – WACC Calculation WACC calculation What is needed: Cost of equity Cost of debt Weight (proportion) of equity Weight (proportion) of debt Tax rate WACC = re ( E ) + rd* ( D ) D+E D+E Where: re rd* E D is the cost of equity is the after tax cost of debt (ie, rd * (1 – t)) is the weight (or value) of equity is the weight (or value) of debt Other terminology: rd = debt required rate of return rd* = cost of debt (rd x (1 – Tax rate)) βu = ungeared beta (or unleveraged beta or asset beta). This is the beta of the company as if it had no debt in the capital structure. βe = equity beta βd = debt beta. The equity beta will rise as more debt is introduced into the company. This indicates that equity is becoming riskier. With APV (adjusted present value); ru = the ungeared return on equity. This is the return on equity as if the company was 100% financed with equity (no debt). 1 EBS – WACC Calculation COST OF EQUITY Two main methods of calculating the cost of equity: 1. Capital Asset Pricing Model (CAPM). rf + e(rm – rf) CAPM: re = Where: rf = risk free rate of interest e = equity beta rm = return on the stockmarket (rm – rf) = equity risk premium (the extra return above the risk free rate gained from investing in the stockmarket To calculate the cost of equity you need to use the equity beta. The company has an asset (ungeared) beta. The asset beta is the weighted average of the equity and debt betas: u = e ( E ) + d ( D ) D+E D+E If the company is all equity (100% equity financed) e = u If the company has debt in its capital structure, the e will be higher than the ungeared (asset) beta u this is because the equity is now more risky as the debt has a prior call on the company cash flows. For example, the following could appear as part of a question: The company is made up of 75% equity and 25% debt, the debt has a beta of 0.2 and the ungeared beta (u) is 1.1. (In a question to calculate the equity beta you will be given the debt beta and t