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What is WACC and how do you calculate it?

The WACC (Weighted Average Cost of Capital) is the discount rate used in a Discounted Cash Flow (DCF) analysis to present value projected free cash flows and terminal value.  Conceptually, the WACC represents the blended opportunity cost to lenders and investors of a company or set of assets with a similar risk profile.  The WACC reflects the cost of each type of capital (debt (“D”), equity (“E”) and preferred stock (“P”)) weighted by the respective percentage of each type of capital assumed for the company’s optimal capital structure.  Specifically the formula for WACC is:  Cost of Equity (Ke) times % of Equity (E/E+D+P) + Cost of Debt (Kd) times % of Debt (D/E+D+P) times (1-tax rate) + Cost of Preferred (Kp) times % of Preferred (P/E+D+P).

To estimate the cost of equity, we will typically use the Capital Asset Pricing Model (“CAPM”) (see the following topic).  To estimate the cost of debt, we can analyze the interest rates/yields on debt issued by similar companies.  Similar to the cost of debt, estimating the cost of preferred requires us to analyze the dividend yields on preferred stock issued by similar companies.

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