Section 1

Weighted Average Cost of Capital (WACC)

Understanding the foundation of discount rates

📖 Key Concept

WACC is the weighted average return required by all providers of capital (equity and debt) to the firm. It acts as the discount rate used to compute the Present Value of Free Cash Flows to the Firm (FCFF).

📊 The WACC Formula

WACC = [ W_e × K_e ] + [ W_d × K_d × (1 - t) ]

Where:

  • W_e = Weight of Equity (% of total capital)
  • K_e = Cost of Equity
  • W_d = Weight of Debt (% of total capital)
  • K_d = Pre-tax Cost of Debt
  • t = Corporate Tax Rate (providing a tax shield on debt)
Section 2

Cost of Equity & CAPM

Calculating the return demanded by shareholders

📈 Capital Asset Pricing Model (CAPM)

K_e = R_f + Beta × (R_m - R_f)

For the Indian Market Context:

  • R_f (Risk-Free Rate): Commonly the 10-Year Indian Government Bond Yield (e.g., ~7.1%).
  • R_m - R_f (Market Risk Premium): The extra return demanded over the risk-free rate for Indian equities (typically 7-9%).
  • Beta (β): Measure of a stock's volatility relative to the NIFTY 50.
📝 Worked Example

Calculating Reliance Industries Cost of Equity

Scenario: You are evaluating Reliance Industries' cost of equity. The current yield on the Indian 10-Yr G-Sec is 7.1%. The Indian market risk premium is adopted at 8.0%. Reliance has an observed levered Beta of 1.10.

Question: Utilizing the CAPM, what is the expected return demanded by Reliance's equity investors?
1
Identify the Variables
Risk Free Rate (R_f) = 7.1%
Beta (β) = 1.10
Market Risk Premium = 8.0%
2
Apply the CAPM Formula
K_e = 7.1% + 1.10 × 8.0%
K_e = 7.1% + 8.8%
K_e = 15.9%
Cost of Equity = 15.90%
Section 3

Cost of Debt

Evaluating the post-tax cost of borrowing

⚠️ Important Tax Shield

Interest payments are tax-deductible. Therefore, the effective cost of debt to the company is lower than the actual interest rate paid. The formula for After-Tax Cost of Debt requires the corporate tax rate (e.g., 25.17% in India for many corporates).

📝 Worked Example

Calculating Reliance's After-Tax Cost of Debt

Scenario: Reliance Industries issues debentures and borrows from banks at a blended pre-tax interest rate of 8.5%. The effective Indian corporate tax rate applies at 25.17%.

Question: What is Reliance's true after-tax cost of debt?
1
Tax Shield Adjustment
After-Tax K_d = Pre-tax K_d × (1 - Tax Rate)
After-Tax K_d = 8.5% × (1 - 0.2517)
2
Calculate Result
After-Tax K_d = 8.5% × 0.7483
After-Tax K_d = 6.36%
After-Tax Cost of Debt = 6.36%
Section 4

Bringing it Together: WACC

Synthesizing capital structure weights with individual costs

📝 Worked Example

Reliance Industries Final WACC

Scenario: Now that we have calculated Cost of Equity (15.90%) and After-Tax Cost of Debt (6.36%), we need to weight them. Reliance currently carries ₹300,000 Cr in debt and has a Market Capitalization of roughly ₹2,000,000 Cr.

Question: What is the final WACC for discounting firm-level cash flows?
1
Calculate Capital Structure Weights
Total Capital = ₹300,000 Cr (Debt) + ₹2,000,000 Cr (Equity) = ₹2,300,000 Cr
Weight of Debt (W_d) = 300,000 / 2,300,000 = 13%
Weight of Equity (W_e) = 2,000,000 / 2,300,000 = 87%
2
Deploy the WACC Formula
WACC = [W_e × K_e] + [W_d × After-Tax K_d]
WACC = [0.87 × 15.90%] + [0.13 × 6.36%]
WACC = 13.83% + 0.83% = 14.66%
Reliance WACC = 14.66%
Excel Lab

Hands-On Practice

Build a complete WACC model

📥 Download Practice Files

Download these files to follow along with the hands-on exercises natively in Excel.

📊
lecture-11-wacc.csv
Reliance metrics practice file
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