"Explain how you calculate WACC."
WACC is the discount rate used in DCF and a core concept in corporate finance. Understanding it demonstrates fundamental financial knowledge.
State the formula: WACC = (E/V × Re) + (D/V × Rd × (1-T)).
Explain each component clearly.
Discuss how to determine cost of equity (CAPM) and cost of debt.
Mention practical considerations.
WACC is the blended rate a company pays across all capital sources. The formula: WACC = (E/V × Re) + (D/V × Rd × (1-T)). E/V is the equity weight, D/V is the debt weight, using market values. Cost of equity (Re) comes from CAPM: Risk-Free Rate + Beta × Equity Risk Premium. I use the 10-year Treasury as risk-free rate, Bloomberg beta, and a 5-7% equity risk premium. Cost of debt (Rd) is the yield on existing debt or comparable credit. The (1-T) reflects the tax shield on interest payments. A key nuance: use target capital structure, not current, for forward-looking analysis. For a typical mid-cap company, WACC might be 8-12%. I always run sensitivity analysis on WACC because small changes significantly impact DCF output.
Know the formula cold — hesitation here is a red flag.
Be ready to discuss each CAPM input in detail.
Mention the tax shield — many candidates forget it.
Market values reflect the true economic cost of capital. Book values may be outdated and do not represent current investor expectations.
Use levered beta from comparable companies, unlever it, then relever to your target capital structure. This is more reliable than using the company's own beta if it is thinly traded.
Initially, adding debt lowers WACC because debt is cheaper than equity (tax shield). But beyond a point, financial distress risk increases both debt and equity costs, raising WACC.
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