Cost of Capital

What is the Cost of Capital?

The expected return by the investors of the company, organization or firm if they have invested in any other securities with comparable degrees of risk.

Capital Structure

The firm’s mix of long term financing and equity financing.

Weighted Average Cost of Capital (WACC)

• Compute the cost of each source of capital
• Determine the percentage of each source of capital in the optimal capital structure
• Calculate Weighted Average Cost of Capital (WACC)
• The overall cost of capital is a weighted average of the various sources, including debt, preferred stock, and common equity

The formula of WACC

WACC = x_d(pretax k_d)(1-Tax rate) + x_psk_ps + x_csk_cs

Whereas; the x’s refer to the firm’s capital structure weights. The k’s refer to the cost of each component.

Let’s move towards some exercise and practice questions:

Exercise 01

Calculate the WACC of the Company if its Debt Structure is:

• Debt                                                                   20%
• Preferred Stock                                               20%
• Common Stock                                                60%
• Corporate Tax Rate                                        35%
• Required Return on Preferred Stock       30%
• Interest Rate on Debt                                    10%
• Opportunity Cost on Retained Earnings 50%

Solution:

• Formula of WACC:           xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
• Where; the x’s refer to the firm’s capital structure weights.
• The k’s refer to the cost of each component.
• WACC = 0.2(0.1)(1-0.35) + 0.2×0.3 + 0.6×0.5
• WACC = 0.373 or 37.30%

Exercise 02

Calculate the WACC of the Company if its Debt Structure is:

• Debt                                                                 25%
• Preferred Stock                                             15%
• Common Stock                                               ?
• Corporate Tax Rate                                       40%
• Required Return on Preferred Stock       40%
• Interest Rate on Debt                                   12%
• Opportunity Cost on Retained Earnings 80%

Solution:

• Formula of WACC:           xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
• Where; the x’s refer to the firm’s capital structure weights.
• The k’s refer to the cost of each component.
• Common Stock = 1 – (Debt + Preferred Stock)
• Common Stock = 1 – (0.25 + 0.15)
• Common Stock = 0.6 or 60%
• WACC = 0.25(0.12)(1-0.4) + 0.15×0.4 + 0.6×0.8
• WACC = 0.558 or 55.80%

Exercise 03

Calculate the WACC of the Company if its Debt Structure is:

• Debt                                                                  30%
• Preferred Stock                                              10%
• Common Stock                                               ?
• Corporate Tax Rate                                        45%
• Required Return on Preferred Stock       45%
• Interest Rate on Debt                                    14%
• Opportunity Cost on Retained Earnings 90%

Solution:

• Formula of WACC:           xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
• Where; the x’s refer to the firm’s capital structure weights.
• The k’s refer to the cost of each component.
• Common Stock = 1 – (Debt + Preferred Stock)
• Common Stock = 1 – (0.3 + 0.1)
• Common Stock = 0.6 or 60%
• WACC = 0.30(0.14)(1-0.45) + 0.1×0.45 + 0.6×0.9
• WACC = 0.6081 or 60.81%

Exercise 04

Calculate the WACC of the Company if its Debt Structure is:

• Debt                                                                 10%
• Preferred Stock                                             20%
• Common Stock                                              ?
• Corporate Tax Rate                                       50%
• Required Return on Preferred Stock       55%
• Interest Rate on Debt                                   16%
• Opportunity Cost on Retained Earnings 70%

Solution:

• Formula of WACC:           xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
• Where; the x’s refer to the firm’s capital structure weights.
• The k’s refer to the cost of each component.
• Common Stock = 1 – (Debt + Preferred Stock)
• Common Stock = 1 – (0.1 + 0.2)
• Common Stock = 0.7 or 70%
• WACC = 0.1(0.16)(1-0.5) + 0.2×0.55 + 0.7×0.7
• WACC = 0.6072 or 60.72%

Exercise 05

Calculate the WACC of the Company if its Debt Structure is:

• Debt                                                                  5%
• Preferred Stock                                              10%
• Common Stock                                               ?
• Corporate Tax Rate                                        40%
• Required Return on Preferred Stock       50%
• Interest Rate on Debt                                    20%
• Opportunity Cost on Retained Earnings 60%

Solution:

• Formula of WACC:           xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
• Where; the x’s refer to the firm’s capital structure weights.
• The k’s refer to the cost of each component.
• Common Stock = 1 – (Debt + Preferred Stock)
• Common Stock = 1 – (0.05 + 0.1)
• Common Stock = 0.85 or 85%
• WACC = 0.05(0.2)(1-0.4) + 0.1×0.5 + 0.85×0.6
• WACC = 0.566 or 56.60%

Exercise 06

Calculate the WACC of the Company if its Debt Structure is:

• Debt                                                                  25%
• Preferred Stock                                              30%
• Common Stock                                               ?
• Corporate Tax Rate                                        60%
• Required Return on Preferred Stock       35%
• Interest Rate on Debt                                    18%
• Opportunity Cost on Retained Earnings 75%

Solution:

• Formula of WACC:           xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
• Where; the x’s refer to the firm’s capital structure weights.
• The k’s refer to the cost of each component.
• Common Stock = 1 – (Debt + Preferred Stock)
• Common Stock = 1 – (0.25 + 0.3)
• Common Stock = 0.45 or 45%
• WACC = 0.25(0.18)(1-0.6) + 0.3×0.35 + 0.45×0.75
• WACC = 0.4605 or 46.05%

Exercise 07

Calculate the WACC of the Company if its Debt Structure is:

• Debt                                                                  60%
• Preferred Stock                                              20%
• Common Stock                                               ?
• Corporate Tax Rate                                        30%
• Required Return on Preferred Stock       45%
• Interest Rate on Debt                                    15%
• Opportunity Cost on Retained Earnings 105%

Solution:

• Formula of WACC:           xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
• Where; the x’s refer to the firm’s capital structure weights.
• The k’s refer to the cost of each component.
• Common Stock = 1 – (Debt + Preferred Stock)
• Common Stock = 1 – (0.6 + 0.2)
• Common Stock = 0.2 or 20%
• WACC = 0.6(0.15)(1-0.3) + 0.2×0.45 + 0.2×0.105
• WACC = 0.174 or  17.5%

BASIC FEATURES OF COST ACCOUNTING

COST BEHAVIOR