WACC Calculation Explained: IB Interview Guide

Key takeaways

WACC is the blended return required by all capital providers — it is the discount rate in every DCF
Cost of equity uses CAPM (Rf + Beta x ERP); cost of debt is the after-tax borrowing rate
Always use market value weights, not book values
More debt initially lowers WACC, but beyond a threshold both Ke and Kd rise — the trade-off theory

What WACC Is and Why It Matters

WACC (Weighted Average Cost of Capital) is the discount rate used in a DCF to convert future cash flows into present value. It represents the blended return required by all capital providers — both equity investors and debt holders.

WACC = (E/V) × Ke + (D/V) × Kd × (1 - t)

Where E = equity value, D = debt value, V = E + D, Ke = cost of equity, Kd = pre-tax cost of debt, t = tax rate.

Step 1: Cost of Equity (CAPM)

Ke = Rf + β × (Rm - Rf)

Rf (Risk-free rate): Use the 10-year government bond yield. Currently around 4-4.5% for UK gilts.
β (Beta): Measures the stock's sensitivity to market movements. Get levered beta from Bloomberg or FactSet. If comparing across capital structures, unlever peer betas and re-lever at the target's structure.
Rm - Rf (Equity risk premium): The excess return investors demand for holding equities over risk-free bonds. Typically 4.5-6% in developed markets.

10.6% Example cost of equity: Rf 4.25% + Beta 1.15 × ERP 5.5%

Step 2: Cost of Debt

The pre-tax cost of debt is the interest rate the company pays on its borrowings. You can find this from the company's bond yields or loan agreements.

After-tax cost of debt: Kd × (1 - t). Interest is tax-deductible, so debt is cheaper than it appears.

Example: Kd = 5.75%, tax rate = 25% → After-tax = 5.75% × 0.75 = 4.3%

Step 3: Capital Structure Weights

Use market values, not book values. For equity: market capitalisation. For debt: market value of outstanding bonds and loans (book value is an acceptable proxy if market data is unavailable).

Example: E/V = 75%, D/V = 25%

Putting It Together

WACC = 75% × 10.6% + 25% × 4.3% = 7.95% + 1.08% = 9.0%

9.0% Final WACC — used as the discount rate in the DCF to derive enterprise value

Common Interview Traps

Common mistake Using book values instead of market values for capital structure weights. Book values reflect historical costs, not what investors would pay today. This would understate the equity weight for most companies.

"What happens to WACC if the company takes on more debt?" — Initially WACC decreases (debt is cheaper than equity). But beyond a certain point, both cost of equity and cost of debt increase due to higher financial risk, and WACC starts rising again. This is the classic trade-off theory of capital structure.

"Should you use book value or market value weights?" — Always market values. Book values reflect historical costs, not what investors would pay today. Using book values would understate the equity weight for most companies.

Insider tip When asked "why do we use levered beta?", explain that you want beta to reflect the actual financial risk of the company, including its debt. If comparing across peers with different leverage, unlever first, then re-lever at the target's structure.

"Why do we use levered beta?" — Because we want the beta to reflect the actual financial risk of the company, including its debt. If comparing across peers with different leverage, unlever first, then re-lever at the target's structure.

Take Your Preparation Further

Download our free Valuation Cheat Sheet with WACC, DCF, and all valuation formulas. For a hands-on model with a built-in WACC calculator, see the DCF Model Template.

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WACC Calculation: The Complete Interview Guide