Weighted Average Cost of Capital

The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt.

WACC = weighted cost of debt + weighted cost of equity

This rate is also known as the Hurdle Rate or Discount Rate. In the definition above, equity can also be broken down into more detailed components as: retained earnings, common stock, preferred stock. The components of a capital can be listed as follows:

• Retained Earnings - Profit the company makes, but does not give to the shareholders in the form of dividends.
• Common Stock  - A security that represents ownership in a corporation.
• Preferred Stock  - A class of ownership in a corporation that has a higher claim on the assets and earnings than common stock.
• Bonds (debt)

The cost of capital is an opportunity cost of finance, because it is the minimum return which an investor requires. For shareholders it is the dividend they expect to receive plus a capital gain on the value of their shares, while for loan holders it is the rate of interest which is quoted on the loan.

For an investment to be worthwhile the expected return on capital must be greater than the cost of capital.

Usually all the equity cost components are represented in a single value as rE. Following is after tax WACC equation:

D       E WACC = rD(1-Tc)--- + rE---                 V       V

• D and E are market value of the firms debt and equity
• Tc marginal corporate tax rate
• rD and rE are cost of debt and equity

Cost of equity rE is the rate that investors expect as a rate of return (expected equity return). And for rD, interest rate or coupon rate is used.

Following is a sample break down of a company's costs.

Capital Component	Cost	Times	% of capital structure	Total
Retained Earnings	10%	x	25%	2.50%
Common Stocks	11%	x	10%	1.10%
Preferred Stocks	%9	x	15%	1.35%
Bonds	6%	x	50%	3.00%
TOTAL		x		7.95%

Sum of all weighted costs give the WACC as 7.95%.

WACC (Weighted Average Cost of Capital) is used to see if certain intended investments or strategies or projects or purchases are worthwhile to undertake.

WACC is expressed as a percentage, like interest. So for example if a company works with a WACC of 12%, than this means that only (and all) investments should be made that give a return higher than the WACC of 12%. The cost of capital for any investment, whether for an entire company or for a project, is the rate of return capital providers would expect to receive if they would invest their capital elsewhere. In other words, the cost of capital is an opportunity cost. 

Example: suppose this company: The Market value of debt = € 300 million. The Market value of equity = € 400 million. The Cost of debt = 8%. The Corporate Tax rate = 35%. The Cost of equity is 18%. Cost of debt = 8% x (1-35%) x 300/700  = 0.022 Cost of equity = 18% x  400/700 = 0.102 WACC = 12.5%

There is also another way of calculating cost of equity using CAPM approach as

Cost of equity = Risk-Free-Rate + (Beta x Market-Risk-Premium).

 

Detailed Analysis of Cost Components

Cost of Retained Earnings

This is kind of weird to think about. It takes some time to understand so take it slowly. After a company makes money (earnings), who owns that money? The shareholders, right? But when you retain earnings you are not giving the money to the shareholders. You are keeping it. In a way, you are investing it for them in your company. Well those shareholders want some return on that money you are keeping.. How much return do they expect? They want the same amount as if they had gotten the retained earning in the form of dividends, and bought more stock in your company with them. THAT is the cost of retained earnings. You as a financial genius, have to ensure that if you are retaining earning, that the shareholders will get at least as good a return on the money as if they had re-invested the money back into the company.

Cost of Issuing Common Stock

Flotation Cost of Common Stock = Costs of issuing the actual stock (ink, printing, paper, computers, etc.) + The cost of retained earnings.

Cost of Preferred Stock

This is another item which is easy to calculate:

Cost of Preferred Stock = (Dividend) / (Stock Price - Underwriting Costs)

Ex: If Company A issues preferred stock, it will pay a dividend of $8 per year and it should be valued at $75 per share. If flotation costs amount to $1 per share cost of preferred stock:

= $8 / ($75-$1) = 10.81%

Cost of Bonds (debt)

The easy part of WACC is the debt part of it. In most cases it is clear how much a company has to pay their bankers or bondholders for debt finance.

Cost of Debt = Coupon rate on the bonds (or interest rate of company's debt) - The Tax Savings

Ex: If Company A issues $1000 par, 20 year bond paying the market rate of 10% and coupons are annual and flotation cost is $50 per bond pre-tax and after-tax cost of debt is:

$1000-$50 = 100 x PVIFA(20,kd) + 1000 x PVIF(20,kd)

kd = 10.62% (Pre-tax cost of debt)

Kd = kd(1-T) = 10.61%(1-.34) = 7% (After-tax cost of debt)

Notes:

PVIFA (Present Value Interest Factor of Annuity)

PVIFA(k,n) = [1-(1+k)^-n]/k

Par Value of Bond (Face Value): This is the amount of money a holder of bond will get back once bond matures.

Tax effect on financial decision

Companies may have an advantage of lowering cost of capital by choosing right capital structure. The obvious advantage is rooted from the fact that interest (debt) is paid before taxes. Following example illustrates this advantage:

	with stock	with debt
EBIT	400,000	400,000
- interest expense	0	(50,000)
EBT	400,000	350,000
- taxes (34%)	(136,000)	(119,000)
EAT	264,000	231,000
- dividends	(50,000)
Retained earnings	214,000	231,000

It appears that when investments are financed through debt there is less earnings left after tax. However companies usually have the commitments to pay dividends to the stockholders when they use equities rather than debt. This dividend is paid after taxes. So companies face more cost in that case.

It is worth to remember that weighted cost of debt has two components as debt ratio rD and tax Tc.

D  Weighted Cost of Debt = rD(1-Tc)---                                   V

The implication of this equation is that if corporate taxes are increased , managers will have more reason to shift out of equity funding as the weighted average of debt falls.