Business case 2 – Technical Document 1

What’s the Weighted Average Cost of Capital (WACC)?

The weighted average cost of capital (WACC) is the global average financial return expected by all the
investors (shareholders and debt holders) who have invested their funds to finance the operating
assets of the company. This annual cost expressed under the form of an interest rate represents the
minimum return to be generated by the company to meet its investors’ expectations. Said in more
basic terms, the WACC is the global cost of raising money for the firm. This technical document
provides a detailed review (although not exhaustive) of the methodology used in practice to compute
the WACC and thus contains several indicative pieces of information that may not be relevant for
direct application in the context of the current finance case.

The traditional and most common way to compute the WACC is to calculate separately the financial
return expected by the shareholders (KE) and the financial return expected by the debt financing
providers (KD) so as to compute an average of those two expected returns weighted by their
respective proportion in the capital structure (also called the financial structure) of the company. The
WACC is then obtained by applying the following formula:

K EVE + K D (1 − T )VD
WACC =
VE + V D

Where KE is the market cost of equity, KD the market cost of debt, VE the equity market value, VD the
debt market value netted from the company’s cash and cash equivalents (net debt market value), and
T is the corporate tax rate.

To apply this formula, there are several intermediary assumptions that have to be properly estimated
using the following methodology:

• The cost of equity (KE): The cost of equity is the minimum market return expected by the
company’s shareholders. The most common model used to assess this cost is the Capital
Asset Pricing Model (CAPM) whose major contribution is to point out that the expected
return of an asset relies on the current market risk free rate increased by a premium
depending on the correlation degree between the risk of the asset and the total risk of
the market. More specifically, the CAPM highlights that the expected return of an asset
under market efficiency should be a linear function of the non diversifiable risk of this
asset and can be estimated through the following formula:

K A = RF + β A ( K M − RF )

Where KA is the asset expected return, RF the market risk free rate and KM the expected
return of a theoretical portfolio representing the whole market (also named the market
expected return). The coefficient βA measures the marginal contribution of the asset to
the total risk of the market and is represented by the following formula:
Cov( K A , K M )
βA =
Var ( K M )

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 Business case 2 – Technical Document 1

The CAPM formula applies to all type of financials assets (bonds, equity stocks, real
estate assets, …). To estimate the cost of equity (KE), we consequently use the following
formula:

K E = RF + β E ( K M − RF )
Where RF is the risk free rate, RM the market expected return, and βE the equity beta. In
practice, a long-term sovereign bond rate (for instance the interest rate of a government
bond) is often used as proxy for the risk free rate (RF) while the historical average return
of a relevant equity market index is often used as a proxy for the expected market return
(RM). There are also some more complex ways to estimate the parameters of the financial
market line. One other possible way to assess the expected market return is to estimate
the future cash flows (after debt repayment) generated by a sample of listed firms used
as a proxy for the whole market and determine the discount rate which will make the
present value of these cash flows equal to the total current market value of the selected
stocks. Such estimations can be performed by externals experts (such as Marline and Co
in the Ace manager game context). The equity beta can be estimated by calculating the
historical covariance between the daily share price return and a daily index return used
as a proxy for the whole market.

• The cost of debt (KD): The cost of debt is the minimum interest rate at which the
company could raise some new funds on the debt market. This rate thus reflects the
forthcoming debt refinancing cost of the company under its future capital structure. For
that reason, the historical debt interest rate can hardly be considered as a good proxy for
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the cost of debt, especially if the current debt of the company is too old and if the
capital structure has changed or is expected to change in the future. In theory, this rate
could also be computed using the CAPM formula since the model applies to all type of
financial assets. In practice however, the average current interest rate observed on debts
recently2 issued by some comparable companies displaying a similar credit rating is often
considered as a good proxy for the cost of debt.

• The capital structure (or market gearing = VD/VE): The capital structure is the mix of debt
and equity chosen by the company to finance its activity. In the WACC formula, this
capital structure has to be expressed in market value terms (and not in accounting value
terms). This means that the equity value used in the formula should be the equity market
value and not the shareholders equity mentioned in the consolidated Balance Sheet. The
debt value should be the debt market value as well, netted from any cash and cash

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In this case, the debt market conditions are very likely to have changed
2
Less than 3 months

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equivalents items potentially owned by the company. That being said, we assume in
practice, that the market value of debt is equal to its accounting value.

In the case of a non-listed firm, the calculation of the WACC raises additional technical problems as
some required parameters such as the equity beta or the market gearing cannot be observed on the
market and are not available. In this case, proxies will have to be made using the average of these
parameters for a sample of comparable trading companies.

• The equity beta (β E) for a non-listed company. A proxy for the equity beta can be
estimated using the average of the betas observed on a sample of comparable listed
companies and by making the required restatements to properly take into account the
sample heterogeneity in terms of capital structure. All the listed companies selected in
the sample (for comparison purposes with the non-listed firm) are unlikely to have the
same capital structure. In this case, the unlevered beta of each comparable company has
to be calculated to exclude the impact of their capital structure on their equity beta. This
unlevered beta is calculated using the Hamada formula :
β equity
β unlevered =
VD
1 + (1 − T ) ×
VE

The sample average of the unlevered betas can then be used as a proxy for the unlevered
beta of the non-listed firm. A proxy for the equity beta will finally be obtained by re-
leveraging this estimated unlevered beta through the same formula (using the target
capital structure of the non-listed firm).

• The capital structure (or market gearing = VD/VE) for a non-listed company: The market
gearing for a non-listed firm is difficult to assess as the market value of the company
cannot be directly observed. A first proxy can be obtained by using the average of a
sample of comparable listed firms. Another way is also to ask the CFO of the firm to give
you his views on this parameter.