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 = xd(pretax kd)(1-Tax rate) + xpskps + xcskcs
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%