Capital budgeting and WACC simulator
Short answer
WACC is the blended after-tax cost of a company's equity and debt, and the discount rate for its projects. A project is worth doing when its NPV at the WACC is positive, which is the same as its IRR exceeding the WACC.
Build the WACC, then test a project
1. Build the WACC
e.g. 10-year Government of Canada bond
26.5% general rate in Ontario
Weighted average cost of capital
8.11%
60% equity at 10.58% + 40% debt at 4.41% after tax
| Build-up | Formula | Value |
|---|---|---|
| Debt-to-equity | D ÷ E | 0.667 |
| Levered beta | βA × (1 + (1 − t) × D/E) | 1.341 |
| Cost of equity | Rf + βL × MRP | 10.58% |
| After-tax cost of debt | Kd × (1 − t) | 4.41% |
| Weights | E/V, D/V | 60.0% / 40.0% |
| WACC | Ke × E/V + Kd(1 − t) × D/V | 8.11% |
2. Evaluate the project
Added to the WACC for riskier projects
Net present value
$182,461
At 8.11% · creates value: accept
IRR
14.53%
+6.42 pts vs rate
Payback
3.57 yrs
Discounted: 4.29 years
NPV sensitivity to the discount rate
| Change | Discount rate | NPV | Decision |
|---|---|---|---|
| −2% | 6.11% | $250,305 | Accept |
| −1% | 7.11% | $215,639 | Accept |
| Baseline | 8.11% | $182,461 | Accept |
| +1% | 9.11% | $150,689 | Accept |
| +2% | 10.11% | $120,248 | Accept |
Year-by-year cash flows
| Year | Cash flow | Salvage | Discount factor | Present value | Cumulative cash | Cumulative PV |
|---|---|---|---|---|---|---|
| 0 | ($1,000,000) | – | 1.0000 | ($1,000,000) | ($1,000,000) | ($1,000,000) |
| 1 | $280,000 | – | 0.9250 | $258,997 | ($720,000) | ($741,003) |
| 2 | $280,000 | – | 0.8556 | $239,570 | ($440,000) | ($501,433) |
| 3 | $280,000 | – | 0.7914 | $221,600 | ($160,000) | ($279,834) |
| 4 | $280,000 | – | 0.7321 | $204,977 | $120,000 | ($74,856) |
| 5 | $280,000 | $100,000 | 0.6771 | $257,317 | $500,000 | $182,461 |
Profitability index 1.18 (PV of inflows $1,182,461 ÷ capex). Cash flows are assumed at year end.
What does the example show?
With a 3.2% risk-free rate, a 5.5% market risk premium, an asset beta of 0.9 and 40% debt, the levered beta is 1.34, the cost of equity is 10.58% and the WACC is 8.11%.
A $1,000,000 project returning $280,000 a year for five years with $100,000 salvage has an NPV of $182,461 and pays back in 3.6 years.
How do I calculate WACC and a project's NPV?
- 1
Lever the beta
Levered beta = asset beta × (1 + (1 − tax rate) × debt/equity).
- 2
Find the cost of equity
Cost of equity = risk-free rate + levered beta × market risk premium (CAPM).
- 3
Weight the costs
WACC = cost of equity × equity share + cost of debt × (1 − tax rate) × debt share.
- 4
Discount the cash flows
Divide each year's cash flow by (1 + WACC) to the power of the year, add the discounted salvage value and subtract the capex. Positive NPV creates value.
Frequently asked questions
What is a good WACC?
There is no single good number: WACC is the minimum return a project must earn. Large, stable Canadian companies often have WACCs of 6% to 9%; smaller or riskier ones are higher.
What is the difference between NPV and IRR?
NPV is the dollar value a project adds at your cost of capital; IRR is the return at which NPV is zero. In the example the NPV is $182,461 at 8.11% and the IRR is 14.53%.
Why lever the beta?
An asset beta reflects business risk only. Borrowing adds financial risk for shareholders, so the equity beta rises with debt; the Hamada formula adjusts for that, with the tax shield on interest.
Where do these numbers come from?
Formulas are standard corporate finance (CAPM, Hamada and WACC). Calculations use decimal arithmetic; IRR is solved by bisection. Inputs are your assumptions.