How to Convert a Debt-Equity Ratio in WACC

Every business utilizes assets to function. These assets, be they employees or machinery, etc., are financed by money or opportunity cost of money (i.e., the assets could have been deployed elsewhere). The business financing may be via bank loan (debt) or form part of the funds belonging to the shareholders (net shareholders funds). One key question in determining the viability of the business is to calculate the cost of all the assets and whether their profitability exceeds that cost. This is important for business managers, to determine if resources are being deployed wisely, or for investors, to know if better returns exist elsewhere.

Assume you have the debt (D) / equity (E) ratio, here defined as D/E.

First, calculate the cost of debt. The cost of debt is easy to calculate, as it is the percentage rate you are paying on the debt. Second, deduct the element that would be offset against tax. Opinions on this step differ. Tax may or may not be deducted at this point to arrive at the true cost of the debt in comparison to the cost of equity (which will not be tax deductible). Assume here that the cost of debt (i) is 6 percent, and that the tax (T) that would be applied is 25 percent.

Calculate the cost of equity. Use the rate of return you believe appropriate for an investment of this type. Equity, also known as shareholders funds, also has a notional cost, though the company is not legally obliged to pay its shareholders for it. However, shareholders are anticipating a reward for the equity they have invested, and this is the cost used. The key problem is determining what the anticipated return or cost should be. Many use what is termed the Capital Asset Pricing Model, CAPM, but it has many problems and may even be a circular exercise. The higher the risk of the business, both operationally and financially, is key. Best is to see what the usual return of comparable businesses without any debt generally is (R) .

Assume here that the cost of equity is 8 percent.

The WACC (Weighted Average Cost of Capital) per annum is then:

[ D_i_(100%-T) ] + [E*R].

Thus 4.5%D + 8%E. Blending the two together, IF the business has Debt of $20m and Equity of $80m, this calculation becomes:

4.5% *20m + 8% * $80m = $7.4m.

One can also express WACC as a yearly percentage rate by combining the two costs of D and E and dividing by their sum.

{[ D_i_(100%-T%) ] + [E*R]} / {D + E}

So, in the above example, $7.4m / $100m = 7.4 %.