Weighted average cost of capital

The weighted average cost of capital (WACC) is the rate that

a company is expected to pay on average to all its security
holders to finance its assets.
The WACC is the minimum return that a company must earn on
an existing asset base to satisfy its creditors, owners, and other
providers of capital, or they will invest elsewhere. Companies
raise money from a number of sources: common equity,
preferred equity, straight debt, convertible debt, exchangeable
debt, warrants, options, pension liabilities, executive stock
options, governmental subsidies, and so on. Different securities,
which represent different sources of finance, are expected to
generate different returns. The WACC is calculated taking into
account the relative weights of each component of the capital
structure. The more complex the company's capital structure,
the more laborious it is to calculate the WACC.
Calculation

In general, the WACC can be calculated with the

following formula:

Where: N is the number of sources of capital

(securities, types of liabilities);
ri is the required rate of return for security i;
MVi is the market value of all outstanding securities i.
Tax effects can be incorporated into this formula. For
example, the WACC for a company financed by one
type of shares with the total market value of MVe and
cost of equity Re and one type of bonds with the total
market value of MVd and cost of debt Rd, in a country
with corporate tax rate t is calculated as:
Capital Structure of Corporations

Corporations need money daily to finance their operating

activities, embark on investment activities and pay taxes, interest
expense, etc. Corporation can raise capital in two ways:

1) Bonds (debt financing)

2) Issue common and preferred shares

What if a corporation does both of these? It can issue bonds

(which are a source of debt) and more common shares (which is a
source of equity). But what's the right mix between the two? How
much debt and how much equity should a company carry? We
answer this question next:

Note: The mix of bonds (debt) and common shares of a

corporation is known as its Capital Structure.

The amount of debt and equity that a company must maintain can
be calculated via the WACC.
Weighted Average Cost of Capital (WACC) is therefore an
overall return that a corporation MUST earn on its existing
assets and business operations in order to increase or
maintain the current value of the current stock. For
example, if Microsoft's WACC is 15% and current stock
price is 28$, then the company must earn a 15% return on
its existing assets and business operations (net income) in
order to MAINTAIN the stock price at $28. The last thing
that corporations would wish to happen is their stock price
falling down!
Example:
Coco Corp. has issued 10,000 units of bonds that are currently selling at
98.5. The coupon rate on these bonds is 6% per annum with interest paid
semi-annually. The maturity left on these bonds is 3 years. The company
has 2,000,000 common shares outstanding with the current stock price at
$10 / share. The stock beta is 1.5, risk free rate for government bonds is
4.5% and the Expected Return on the Stock Market is 14.5%. The tax rate
for the corporation is 30%.

Bond Calculations Stock Calculations

N=3x2=6
I/Y = ? (Rd) Re = Rf + B[Rm - Rf]
PV = 0.985 x 10,000 x $1000 = Re = 0.045 + 1.5 [0.145 - 0.045]
$9,850,000 (D) Re = 0.045 + 0.15 = 0.195
PMT = (-10,000,000 x 0.06) / 2 = (19.5%)
$-300,000 Market Value of Equity = E
FV = $-10,000,000 Stock price x common shares
P/Y = 2 O/S
C/Y = 2 $10 x 2,000,000 = $20,000,000
Solution: I/Y = 6.56%
V = Total Capital Structure
V = 9,850,000 (bonds debt) + 20,000,000 (equity of common
shares)
V = 29,850,000

Summary of Important Terms

Rd = 6.56% = 0.0656
D = 9,850,000
V = 29,850,000
D/V = 9,850,000 / 29,850,000
Re = 0.195
E = 20,000,000
E/V = 20,000,000 / 29,850,000 = 0.67
(1-T) = (1 - 0.3) = 0.7

WACC = [Rd x D/V x (1-5)] + [Re x E/V]

= [(0.0656) (0.33) (0.7)] + [(0.195) (0.67)]
= 0.01515 + 0.1307 = 0.1458 of WACC-> 14.58%
INTERPRETATION

A WACC of 14.58% means Coco Corp. must earn a

return of 14.58% on all its assets and business
operations in order to MAINTAIN the current stock
price at $10 per share. If Coco Corp. wants greater
than its stock price to go higher, it must achieve a
return rate 14.58%
Cost of equity

Cost of equity is the return (often expressed as a rate of

return) a firm theoretically pays to its equity investors
such as shareholders to obtain their capital. Firms need
to acquire capital from others to operate and grow.
Individuals and organizations who are willing to provide
their funds to others naturally desire to be rewarded.
Just as landlords seek rents on their property, capital
providers seek returns on their funds.
Calculations:

Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta x (market rate of return-
risk free rate of return) Where Beta= sensitivity to movements in the
relevant market:

Where:
Es, The expected return for a security
R f, The expected risk-free return in that market (government
bond yield)
βs, The sensitivity to market risk for the security
RM, The historical return of the stock market/ equity market
(RM-Rf), The risk premium of market assets over risk free assets.

The risk free rate is taken from the lowest yielding bonds in
the particular market, such as government bonds.
Expected return:

The expected return (or required rate of return for investors) can be
calculated with the "dividend capitalization model", which is

Comments:

The models state that investors will expect a return that is the risk-
free return plus the security's sensitivity to market risk times the
market risk premium.

The risk premium varies over time and place, but in some
developed countries during the twentieth century it has averaged
around 5%. The equity market real capital gain return has been
about the same as annual real GDP growth. The capital gains on
the Dow Jones Industrial Average have been 1.6% per year over
the period 1910-2005. The dividends have increased the total "real"
return on average equity to the double, about 3.2%.
The sensitivity to market risk (β) is unique for each firm and
depends on everything from management to its business and
capital structure. This value cannot be known "ex ante"
(beforehand), but can be estimated from ex post (past) returns and
past experience with similar firms.

Cost of retained earnings/cost of internal equity:

Note that retained earnings are a component of equity, and

therefore the cost of retained earnings (internal equity) is equal to
the cost of equity as explained above. Dividends (earnings that are
paid to investors and not retained) are a component of the return on
capital to equity holders, and influence the cost of capital through
that mechanism.
Cost of debt:

The cost of debt is computed by taking the rate on a risk free bond
whose duration matches the term structure of the corporate debt,
then adding a default premium. This default premium will rise as the
amount of debt increases (since, all other things being equal, the
risk rises as the amount of debt rises). Since in most cases debt
expense is a deductible expense, the cost of debt is computed as
an after tax cost to make it comparable with the cost of equity
(earnings are after-tax as well). Thus, for profitable firms, debt is
discounted by the tax rate. The formula can be written as

(Rf + credit risk rate)(1-T),

where T is the corporate tax rate and Rf is the risk free rate.
REASON:

* If the cost of components high the weighted average cost of capital

increases and reason is that shareholder prefer to use of debt
when expected value of tax benefit is attractive as compared to
the added financial risk associated with the debt.

* The cost of equity and debt increases with the increase in debt.

* The Demanded rate of increase in cost of debt and equity, effects

on value of the expected increase in tax benefit of using more
debt.

* Equity financing cannot create a tax advantage because dividends

are paid after interest and tax.

* Debt financing becomes attractive when tax is deductable from

interest.
RECOMMENDATION:
Cost of capital become low that could lower by the management in
down market through viewing current corporate governance
themes, taking action on giving management training with respect
to capital market issues of today and advanced planning to identify
the potential investors.