1. Introduction

So far, we have seen what the WACC is and how we use it in firm valuation. This section takes a brief look at how to estimate the WACC in practice.  This typically involves the following steps:

 

  • Identify the firm's current capital structure (D/(D+E)), in market values
  • Obtain the firm's (marginal) tax rate (\( \tau_C \))
  • Estimate the firm's cost of equity (\( k_E \)) under the current capital structure
  • Estimate the firm's cost of debt (\( k_D \)) under the current capital structure.

 

For a listed company, an acceptable first-pass approximation to identify the current capital structure is to use the book value of debt as a proxy for its market value (D) and to obtain the market value of equity (E) by multiplying the number of shares outstanding with the current share price. Later, will discuss how we can estimate the WACC for non-traded firms.

 

The firm's marginal tax rate (\( \tau_C \)) can often be obtained from the annual report. Alternatively, we can also use the statutory tax rate from the company's location of incorporation.

 

In most instances, estimating the cost of debt (\( k_D \)) and equity (\( k_E \)) is the tricky part in obtaining an estimate for the WACC. A detailed discussion of these issues goes beyond the scope of this introductory course. The following two sections provide a short introduction into this topic.