Weighted Average Cost of Capital
by
Zubair Ali Raja, Ph.D.
Learning Objectives
What is firm’s cost of capital
How to calculate the component costs of capital using
different methods
How to calculate weighted average cost of capital
Key Terms
Weighted average cost of capital (WACC)
Before-tax cost of debt ()
After-tax cost of debt ()
Cost of preferred stocks ()
Cost of common stocks ()
Setting the Stage
Firm’s cost of capital is based on the return demanded
by investors
Firm should know its cost of capital
Components of capital:
Long-term Debt LD=$30000, PS=10,000 and CS=60,000
Preferred Stocks Total Capital= $100,000
, = 0.1 and = 0.6
Common Stocks
WACC= + (
Setting the Stage
We calculate a firm’s cost of capital by
Calculating each of the components capital costs, and
then
Calculating a weighted average of these costs relative to
how much of each type of funding the company is using
WACC= + (
Cost of Debt
WACC= + (
Three methods:
Method 1: Ask an investor banker what the coupon rate
would be on new debt.
Method 2: Find the bond rating for the company and use
the yield on other bond with a similar rating.
Method 3: Find the yield on the company’s debt, if it has
any
Method 3: Calculating the YTM
Assume a bond with the following
characteristics:
15 year maturity, 12% semiannual coupon;
selling for $1,153.72 with the face value of
0 $1,000.1 What’s
2 3 4
i=?
30
PV=- 1,153.72 60 60 60 60 6 0 +1000
N=30, I/Y=?, PV=-1,153.72, PMT=60, FV=1,000
I/Y= 5%, YTM= 5% x 2 = 10% =
Component Cost of Debt:
GOOD NEWS! Interest expense is tax
deductible
After-tax cost of debt ‘’
= (1 –T)
Where ‘T’ is the tax rate, T= 40%
= 10% (1- 40%)= 10% - 4% = 6%
WACC= + (
WACC= + (
Cost of Preferred Stock:
WACC= + (
Let’s say we have the following preferred stock
Price of PS today is $116.95
Dividend is 10% (paid quarterly) on par value of $100
Floatation Cost (F) is 5% of total price
= = = =9%
High floatation cost
No tax adjustments
Cost of Common Stock (equity):
WACC= + (
Two ways company can raise equity
Retained Earning
Issuing new common stocks
Method to calculate cost of common stock
CAPM
DCF
Own-Bond-Yield-Plus-Judgmental-Risk Premium
Method 1: CAPM
From CAPM topic we know that
= ()
Assume the following:
=5.6% , = 11.6%, =1.2 then:
=5.6% +1.2(11.6%-5.6%) = 12.8 %
Method 2: DCF
From stock evaluation topic we know that
= =
Assume the following:
=$3.12 , = $50 , =5.8% then:
= + 0.058
= 6.6%+5.8% = 12.40%
Estimating the Growth Rate
Use the historical growth rate if you believe
the future will be like the past
Obtain analysts’ estimates
Estimating the Growth Rate
Using earning retention model:
Say, ROE=15% and Payout ratio =62%
Expected future growth rate=g=?
g= retention rate * ROE
g= (1- payout rate) * ROE = (1- 0.62)*
15%
g=5.7%
Method 3: Own-Bond-Yield Plus Judgmental
Risk Premium
If the company has bonds in the market
then we can apply a risk premium to the
price of those to estimate the cost of
common stock.
Example:
Assume:
= + Judgmental risk premium
= 10% + 3.2% =13.2%
Cost of Common Stock: Wrap-up
We can use one method or different
methods
We can take and average
Methods Estimates
CAPM 12.80 %
DCF 12.40 %
Average 12.60 %
Weighted Average Cost of Capital:
Once we have all the component costs we need to
then calculate a weighted average of all these costs
This method is known as the Weighted Average
Cost of Capital or WACC
WACC= (+ (
Where: = (1-T)
The weights are the percentage total of that
financing source compared to all financing sources
Estimating the Weights: Step 1
Start by calculating the total value of all funding
sources
Suppose the stock price is $50, there are 3 million
shares of stock, the firm has $25 million of preferred
stock, and $75 million of debt.
Total value of the company can be calculated using:
= $50(3 million) = $150 million
= $25 million
= $ 75 million
Total value = = $150 + 25 + 75 = $250 million
Calculating the total value: Step 2
WACC= (+ (
Weights calculation:
= / = 75/250 = 0.30
= / =25/250= 0.10
= / = 150/250= 0.60
Putting it All Together
WACC= +
WACC= +
= 1.8% + 0.9% + 7.56% = 10.38%
Now what???
That was a lot of effort to calculate the WAC
But it will be put to good use
Wrapping it Up
A company’s cost of capital is the weighted average of
all its component capital cost
To calculate this we calculate each component cost
separately
Debt (after tax)
Preferred stocks
Common stocks
Calculate weights of each component
WACC formula:
WACC= +
Example
Question: Company XYZ has ‘4,000’ outstanding
bonds with the face value of $1000 each and
currently trading at $950 each. These bonds will
mature in five years and offer annual coupon
payment of $90 paid twice a year. Company has
100,000 outstanding common shares, trading at $80
each share. Risk free rate ‘is 3% and market premium
is 4%. Beta of the stock is 2. If the corporate tax rate
‘T’ is 35%, what is the firm’s WACC?
Hints: Need to use CAPM and YTM to find
component costs. Also, calculate market values of
each funding type.
