1
WACC Framework
What is WACC?
The Weighted Average Cost of Capital (WACC) is the blended cost of all capital sources, weighted by their market-value proportions. It represents the minimum return a company must earn to satisfy all capital providers — debt holders, preferred shareholders, and equity holders.
WACC Formula
WACC = Ke × (S/V) + Kp × (P/V) + Ki × (D/V)
Where:
Ke = Cost of equity
Kp = Cost of preferred equity
Ki = After-tax cost of debt = Kd × (1 − Tax Rate)
S = Market value of equity
P = Market value of preferred
D = Market value of debt
V = S + P + D (total firm value)
Critical: WACC is the discount rate for unlevered free cash flows (UFCFs). It reflects the cost of capital for the entire enterprise, regardless of how it is financed.
3-Step WACC Process
- 1Estimate Capital Structure Weights — Use market values, not book values. For listed companies: equity = shares × price. For debt: use market value of each instrument. Use the long-term sustainable target structure, not current snapshot.
- 2Estimate Marginal After-Tax Costs — Cost of debt: YTM of existing debt (after-tax). Cost of preferred: Dp / market price. Cost of equity: CAPM. Use marginal (forward-looking) costs, not historical average.
- 3Calculate Weighted Average — Multiply each component's cost by its weight, sum the results.
Common error: Using book values for weights distorts WACC, especially for equity. Book value of equity can be far below market value for mature, profitable companies. Always use market values.
Typical Capital Structure Weights
| Component | Typical Weight Range | Notes |
|---|---|---|
| Debt (bonds, bank debt) | 20–30% | Higher for utilities, real estate; lower for tech |
| Preferred Equity | <5% | Relatively rare in modern capital structures |
| Common Equity | 70–80% | Dominant component for most companies |
2
Cost of Capital Components
Cost of Debt (After-Tax)
After-Tax Cost of Debt
Ki = Kd × (1 − T)
Where: Kd = pre-tax yield on debt (YTM)
T = marginal corporate tax rate
Example: Kd = 4.5%, T = 35%
Ki = 4.5% × (1 − 0.35) = 2.925%
- Interest payments are tax-deductible → the government subsidizes a portion of debt financing
- Use the YTM of the company's existing bonds (or new issue yield), not the coupon rate
- For bank debt, use the actual rate paid, adjusted for taxes
Cost of Preferred Equity
Cost of Preferred
kp = Dp / Pp
Where: Dp = annual preferred dividend
Pp = current market price of preferred
Example: Dp = $1.85, Pp = $23.13
kp = $1.85 / $23.13 = 8.0%
Market Value of Preferred:
MV_pref = Dp / kp = $1.85 / 0.08 = $23.125 per share
Total: 3.5M shares × $23.125 = ~$80.94M
Preferred dividends are paid from after-tax income (not deductible), so no tax adjustment needed. The formula is the perpetuity formula (C/r) — preferred typically has no maturity.
Cost of Equity — CAPM
Capital Asset Pricing Model (CAPM)
Re = Rf + β × (Rm − Rf)
= Rf + β × MRP
Where:
Rf = Risk-free rate (10-year government bond yield)
β = Beta (systematic risk relative to market)
MRP = Market Risk Premium (Rm − Rf)
= expected return on market − risk-free rate
Typically: 5%–6% in Canada/US
| Input | Source | Typical Value |
|---|---|---|
| Risk-Free Rate (Rf) | 10-year government bond yield | 3–5% (varies with cycle) |
| Beta (β) | Bloomberg; regression of stock vs. market returns | >1 = more volatile; <1 = less volatile |
| Market Risk Premium (MRP) | Historical estimates; Damodaran data | 5–6% (Canada/US) |
Example: Rf = 3.5%, β = 1.2, MRP = 5.5%
Re = 3.5% + 1.2 × 5.5% = 3.5% + 6.6% = 10.1%
Re = 3.5% + 1.2 × 5.5% = 3.5% + 6.6% = 10.1%
Illustrative Full WACC Calculation
| Component | Market Value ($M) | Weight | Cost | Weighted Cost |
|---|---|---|---|---|
| Bonds (Debt) | $23M | 20.00% | 2.925% (after-tax) | 0.585% |
| Preferred | $3M | 2.61% | 8.00% | 0.209% |
| Common Equity | $89M | 77.39% | 10.00% | 7.739% |
| Total / WACC | $115M | 100% | — | 8.4478% |
3
DCF Methodology — 8-Step Process
The 8-Step DCF Waterfall
- 1Forecast Unlevered Free Cash Flows (UFCF) — Project revenue, margins, capex, and working capital for a 5–10 year explicit period. UFCF represents cash available to all capital providers (before interest payments).
- 2Calculate WACC — Using the 3-step process above. This is the discount rate applied to UFCFs.
- 3Calculate Terminal Value (TV) — Capture the value of all cash flows beyond the explicit projection period (typically 50–70% of total EV).
- 4Discount UFCF & TV to Present Value — Apply WACC as discount rate. NPV of each period's UFCF plus NPV of TV.
- 5Sum to Enterprise Value (EV) Range — Build a sensitivity table (WACC × terminal value assumption) to produce a range, not a point estimate.
- 6Adjustments to EV — Add: excess cash, non-operating assets. Subtract: unfunded pension liabilities, environmental liabilities, earnouts.
- 7Less Net Debt — Subtract net debt to get from Enterprise Value to Equity Value. Net Debt = Debt + Preferred + Capitalized Leases + Minority Interest − Cash − LT Investments.
- 8Equity Value Per Share — Divide equity value by fully diluted shares outstanding (include options, warrants, convertibles using treasury stock method).
Enterprise Value ↔ Equity Value Bridge
Enterprise Value = Equity Value + Net Debt
Equity Value = Enterprise Value − Net Debt
Net Debt = Total Debt + Preferred + Cap. Leases
+ Minority Interest − Cash − LT Investments
Building UFCF — The Cash Flow Waterfall
Revenue
COGS, SG&A, other operating costs
EBITDA
Depreciation & Amortization
EBIT (Operating Income)
Unlevered Cash Taxes (= EBIT × Tax Rate, ignores interest deduction)
Unlevered Net Income (NOPAT)
Depreciation & Amortization (add back — non-cash)
Capital Expenditures
Increase in Working Capital (or + decrease)
Unlevered Free Cash Flow (UFCF)
EBITDA sourcing: Always pull EBITDA from the Cash Flow Statement, not the Income Statement. D&A is sometimes hidden in COGS on the income statement and cannot be separately identified.
Projection Period Guidelines
- Explicit projection period: typically 5–10 years
- Sanity check rule: NPV of UFCF from the projection period should represent 30–50% of total enterprise value. If it's only 10–15%, your terminal value is carrying too much weight — extend the projection period or reconsider assumptions.
- Revenue CAGR and margin assumptions must be defensible and sector-consistent
- Working capital: growing companies typically consume WC as they scale; WC release is a tailwind in declining businesses
4
Terminal Value & Sensitivity Analysis
Terminal Value Methods
Method 1: Perpetuity Growth Rate (PGR) Recommended
TV_n = UFCF_n × (1+g) / (r − g)
Where:
UFCF_n = last year's free cash flow
g = long-run perpetual growth rate
r = WACC
Implied sustainable growth rate:
g should ≈ long-run nominal GDP growth
(typically 1.5%–3% in developed markets)
Method 2: EBITDA Multiple Use with caution
TV_n = Exit EBITDA Multiple × EBITDA_n
Where:
Multiple = observed trading comps multiple
EBITDA_n = last projected year's EBITDA
Tends to overvalue businesses by embedding
current market pricing into the terminal value.
Circular when used with current trading comps.
Sanity check — always cross-validate:
- If using PGR method → calculate the implied EBITDA multiple the TV represents. Compare to trading comps.
- If using EBITDA multiple → solve for the implied PGR. Confirm it is reasonable vs. nominal GDP.
Sensitivity Analysis — The Football Field
Never present a single DCF value. Build a sensitivity table (WACC vs. terminal value assumption) to show a valuation range.
Illustrative Sensitivity: WACC vs. PGR → EV Range
WACC: 8.5% 9.0% 9.5% 10.0% 10.5% 11.0%
g=3%: $1,181 $987 $845 $735 $652 $587
g=4%: higher lower
g=5%: highest lowest
→ EV range: $525M to $1,181M
→ Equity/share: $4.75 to $11.31 (100M shares, $20M net debt)
What Drives DCF Most
✓✓✓✓✓ Sales growth rate
✓✓✓✓✓ EBITDA margin
✓✓✓✓✓ Terminal value (PGR or multiple)
✓✓✓✓ Beta / cost of equity
✓✓✓✓ Risk-free rate
✓✓✓✓ Market risk premium
✓✓✓✓✓ EBITDA margin
✓✓✓✓✓ Terminal value (PGR or multiple)
✓✓✓✓ Beta / cost of equity
✓✓✓✓ Risk-free rate
✓✓✓✓ Market risk premium
Key Relationship
WACC ↑ → EV ↓ (higher discount rate → lower present values)
g (PGR) ↑ → EV ↑ (higher terminal growth → higher terminal value)
EBITDA Multiple ↑ → EV ↑
g (PGR) ↑ → EV ↑ (higher terminal growth → higher terminal value)
EBITDA Multiple ↑ → EV ↑
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Illustrative Full DCF Example
Assumptions
| Input | Value |
|---|---|
| Base Year Revenue | $1,000M |
| Projection Year Revenue (LFY+5) | $2,074M |
| Revenue CAGR | 17.5% |
| EBITDA Margin | 10.5% (stable) |
| UFCF Range (Years 1–5) | $23M → $53M per year |
| WACC | 10.0% |
| Perpetuity Growth Rate (g) | 1.9% |
| Net Debt | $20M |
| Shares Outstanding | 100M |
DCF Calculation Walk-Through
Step 1: Terminal Value at LFY+5
UFCF(LFY+5) = $92.7M (based on projected EBITDA margin)
TV = $92.7M × (1 + 1.9%) / (10.0% − 1.9%)
= $92.7M × 1.019 / 0.081
= ~$1,166M (projected) → NPV = $944.1M after discounting
Alternatively shown as: TV ≈ $1,166M / (1.10)^5 × correction ≈ $944.1M
Step 2: NPV of Projection Period UFCFs
NPV of Years 1–5 UFCFs = $331.7M (≈ 26% of total EV)
Step 3: Enterprise Value
Total EV = NPV of UFCFs + NPV of TV
= $331.7M + $944.1M
= $1,275.8M
Step 4: Equity Value Per Share
Equity Value = EV − Net Debt = $1,275.8M − $20M = $1,255.8M
Per Share = $1,255.8M / 100M shares = $12.56/share
Sanity check: NPV of UFCFs ($331.7M) / Total EV ($1,275.8M) = 26%. This is slightly below the 30–50% guideline, suggesting the terminal value is carrying significant weight — acceptable but worth noting in a board presentation.
EBITDA Multiple Sensitivity (Cross-Validation)
| Exit Multiple | WACC 8.5% | WACC 10.0% | WACC 11.0% |
|---|---|---|---|
| 5× EBITDA | $765M | $680M | $620M |
| 7× EBITDA | $1,100M | $980M | $900M |
| 9× EBITDA | $1,430M | $1,275M | $1,175M |
A 7× multiple at 10% WACC yields ~$980M EV, consistent with the PGR method at g=1.9%. This convergence provides confidence in the valuation range.
★
Formula Reference — Session 3
Complete Formula Sheet
WACC
WACC = Ke(S/V) + Kp(P/V) + Ki(D/V)
After-Tax Cost of Debt
Ki = Kd × (1 − T)
Cost of Preferred
kp = Dp / Pp
CAPM — Cost of Equity
Re = Rf + β × (Rm − Rf) = Rf + β × MRP
UFCF Build
UFCF = EBITDA − D&A − Unlevered Taxes + D&A − CapEx − ΔWC
= NOPAT + D&A − CapEx − ΔWC
Unlevered Taxes = EBIT × Tax Rate
Terminal Value — Perpetuity Growth Rate
TV_n = UFCF_n × (1+g) / (WACC − g)
Terminal Value — EBITDA Multiple
TV_n = Exit Multiple × EBITDA_n
Enterprise Value (DCF)
EV = NPV(UFCF, Years 1–n) + NPV(TV_n)
= Σ [UFCF_t / (1+WACC)^t] + TV_n / (1+WACC)^n
Net Debt
Net Debt = Debt + Preferred + Cap. Leases + Minority Interest
− Cash − LT Investments
Equity Value
Equity Value = Enterprise Value − Net Debt
Equity Value Per Share
Share Price = Equity Value / Fully Diluted Shares Outstanding
DCF 8-Step Checklist
| Step | Action | Key Watch-Out |
|---|---|---|
| 1 | Forecast UFCF | Use Cash Flow Statement for EBITDA; include WC changes |
| 2 | Calculate WACC | Market value weights; marginal cost of each component |
| 3 | Calculate Terminal Value | PGR ≤ long-run nominal GDP; cross-validate with multiple |
| 4 | Discount to PV | Discount TV back full n periods; UFCFs at mid-year if appropriate |
| 5 | Sum to EV Range | Build sensitivity table — range > point estimate |
| 6 | Adjustments | Add non-operating assets; deduct contingent liabilities |
| 7 | Less Net Debt | Include all debt-like items (leases, minorities, pension deficit) |
| 8 | Equity Value Per Share | Use fully diluted shares (treasury stock method for options) |