While valuing an organization using Discounted Cash Flow (DCF), forecasted Free Cash Flow (FCF) is discounted by the *Weighted Average Cost of Capital (WACC)*. WACC represents the opportunity cost of capital for investors when they allocate their funds towards a business.

WACC can be calculated using the following formula:

**WACC = D/V x Kd (1 – T) + E/V x Ke**

Where,

D/V = Debt to Enterprise Value (EV) based on market value

E/V = Equity to EV based on market value

Kd = Cost of debt

Ke = Cost of equity

T = Company’s tax rate

None of the above components are readily available. Hence, we use various models, assumptions and approximations to arrive at each of the values. There are 3 important factors that need further attention.

**Cost of equity**is depended on (1) Risk-free rate (2) Market risk premium and (3) Beta. We employ CAPM to estimate the cost of equity.**After-tax cost of debt**depends on (1) Risk-free rate (2) Default spread and (3) Marginal tax rate. For an investment grade company, we employ yield to maturity (YTM) on its long-term debt, and for a public company, we use YTM on bonds’ cash flows and price.**Capital Structure**(proportion of debt and equity to the EV). The target capital structure is derived by the company’s current debt-to-value ratio. We always use the market values (and not the book values).

**Couple of points noteworthy:**

- WACC based models works well when a company maintains a relatively stable debt-to-value ratio. But for a LBO, it can understate or overstate the impact of the tax shield. In such a situation, we should discount the FCF at unlevered cost of equity and value tax shields separately.
- If a company’s debt-to-value ratio changes, we use Adjusted Present Value (APV).

Let’s take an **example**. Consider a startup wants to raise a capital of $1 million so that it can buy office space and equipments needed to run its business. The company issues 6,000 shares at $100 each to raise $600,000. The shareholders expect a return of 10% on their investment. So, the cost of equity is 10%.

The company then issues 400 bonds of $1,000 each to raise $400,000. The bondholders expect a return of 8%. So, the cost of debt is 8%.

Now, the startup’s total market value ($600,000 equity + $400,000 debt) = $1 million. Let’s assume its tax rate is 35%. So, the company’s WACC is 6%

(($600,000/$1,000,000) x 0.1) + [(($400,000/$1,000,000) x .08) x (1 – 0.35))] = 0.0598 ~6%

This means that for every $1 the start-up raises from its investors, it must return $0.06 to them.

You may also want to read about Enterprise Value here.