Weighted Average Cost of capital (WACC) is a capital that the company raises from various sources which include raising money through listing the company shares on the stock exchange (Equity), preferred stock, or by interest-paying bond or taking commercial loans (debt). The cost of each type of capital is weighted by its percentage of total capital and cost are added together. It is calculated by weighting the cost of equity and the after-tax cost of debt by their relative weights in the capital structure.
Formula
The company classified into two sources of financing –debt and equity. WACC is calculated by using the following formula:
WACC = Ke* E/ E+D + Kd *(1-t) * D/ E+ D
Where,
Ke equal cost of capital
E equals market value of equity
Kd equals pre-tax cost of debt
t equal tax rate
D is the market value of debt, and
E/ (E+D) and D/ (E+D) are weights assigned on equity and debt in the company’s capital structure.
Cost of Equity
It is the required rate of return on common stock of the company. Cost of equity is estimated using different models, such as dividend discount model (DDM) and capital asset pricing model (CAPM).
After Tax Cost of Debt
After tax rate of return which the debt holder earns till the maturity of the debt .If yield to maturity is excluded, the cost can be estimated using the instrument current yielded.
WACC is calculated using after tax cost of debt because debt offers a tax shield i.e. interest expenses on debt reduces taxes.
Equity and Debt Weights
E/A weight of equity in the company’s total capital. It is computed by dividing the market value of the company equity by the sum of the market values of equity and debt.
D/A is the weight of debt component in the company’s capital structure .It is calculated by dividing the market value of the company’s debt by the sum of the market value if equity and debt.
Example
Hydropower, Inc. went public by issuing 1 million shares of common stock @$20 per share. The shares are currently trading at $20 per share. The risk free rate (RFR) is 4%, market risk premium (MRP) is 8% and the company has a beta coefficient of 1.2.
In prior years, it issued 50,000 bonds of $1,000 par paying 10% coupon annually maturing in 20 years. The bonds are currently trading at $950.If the tax rate is 30%. Calculate the weighted average cost of capital.
Solution:
Calculating the proportion of equity and debt of hydropower
Current Market value of equity
=1,000,000*$20
=$20,000,000
Current Market value of Debt
=50,000*$950
=$47,500,000
Total market value of debt and equity
=$67,500,000
Weight of equity
=$30,000,000/ $67,500,000
=44.44%
Weight of Debt
=$47,500,000/$67,500,000
=70.37%,
Estimating cost of equity
It is calculated by estimating either the dividend discount model (DDM) or capital asset pricing model (CAPM).
Cost of equity, using CAPM method
Rfr + β * MRP
=4%+1.2 * 8%
=13.2%
Estimating cost of debt
= (10.61% *(1-30%)
=7.427%
Calculating WACC
=44.41%*13.6%+70.37%*7.427%
=11.26%
From the above, for example, the cost of different components is weighted according to their proportion in the capital structure and the n summarized.