For consistency, the estimate of the WACC should have the following properties:
- it includes the opportunity cost of all investors,
- it uses the appropriate market-based weights,
- it includes related costs/benefits such as the interest tax shield,
- it is computed after corporate taxes,
- it is based on the same expectations of inflation as used in the FCF forecasts, and
- the duration of the securities used in estimating the WACC equals the duration of the FCFs.
D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate
WACC = D/V * kd (1 - Tm) + E/V * ke
Cost of equity
The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.
It includes an estimate of
- the risk free rate,
- beta, and
- the market risk premium.
Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)
Note: there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.
Cost of debt
The after tax cost of debt requires
- an estimate of the required return on debt capital and
- an estimate of the tax rate.
Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure