WACC (Weighted Average Cost of Capital)
Introduction
Weighted Average Cost of Capital (WACC) is the cost of debt and cost of equity from company perspective. The required rate of return is from the investors’ perspective which is the return required to benefit the investor for the perceived level of risk.
The cost of capital is from the company perspective, which is the minimum return the company must produce to benefit investors.
Inequality of investor rate of return and company cost of capital
Both investor required rate of return and company cost of capital are not equal because company received tax relief on the interest, e.g. for investment in debenture issued by the company @ 10% interest with corporate tax @ 30% has rate of return for investor 10% but company cost of capital is 7% (10% x (1-30%) with is net of corporate tax of 30%.
Equity
The capital which is raised through issue of share capital to the shareholders of the company.
Debit
The capital which is raised through investors by issuing bonds, debentures against rate of return.
COST OF CAPITAL
Explanation of key words used in Weighted Average Cost of Capital (WACC)
Cost of capital (Ke)
It is the weighted average of cost of equity (Ke) and it is denoted by Ke. cost of debt is denoted by Kd (1-t) i.e. after taxation.
Cost of Debt (Kd)
It is denoted by Kd (1-t) i.e. after taxation. cost of debt Kd (1-t). The weightings are proportion of market value of debt and equity. For instance, a company has market value of equity of Rs.60 million and market value of debt Rs.40 million so weights shall be 60% equity and 40% debt.
Formula of Weighted Average Cost of Capital (WACC)
Where,
Ke = Cost of equity
Kd = Cost of debt
E = Market value of equity
D = Market value of debt
t = Corporate tax rate
1-t = After tax
How to calculate cost of equity Ke
Cost of equity is calculated through Dividend Valuation Model and Capital Asset Pricing Model (CAPM)
Dividend Valuation Model (DVM)
Dividend Valuation model calculates market value of shares by taking present value of future dividends.
When the company do not show any growth in the dividend below formula is used;
D = constant dividend from year 1 to infinity
Po =share price now at year zero (it is ex dividend share price)
Ke = shareholders’ required return in %
Example:
A company has paid Rs.2 dividend for many years, market value of the share is Rs.25. Calculate cost of equity Ke.
To calculate Ex Div Share i.e. Po the formula is;
DVM – Constant Growth
When the company shows constant growth in the dividend below formula is used;
DVM with Growth
Where,
g = constant rate of growth in dividends in %, Do (1+g) dividend at the end of year 1
Po = share price now at year zero (it is ex dividend share price)
Ke = shareholders’ required return
Example:
A company has paid Rs. 2 dividend with growth rate of 8% , market value of the share is Rs.25. Calculate cost of equity Ke.
To calculate Ex Div Share i.e. Po the formula is;
CAPITAL ASSET PRICING MODEL (CAPM)
Required return = Risk free return + systematic risk premium
Ra = Rf + (Rm – Rf) x Ba
Where,
- Ra = Required return
- Rf = Risk free rate of return which is normally on government bills
- Rm = Average market return.
- Rm – Rf = Market risk premium, this is the reward that investors over and above investment in risk free securities
- Ba = Systematic risk of security / shares
How to calculate cost of equity Kd
Types of debts
Irredemable Fixed Rate Debt
Irredemable means debt shall not be repaid and interest is paid in perpetuity.
Therefore, market value of the debt is the present value of future interest discounted at Kd which is rate of return of debt providers.
Formula of Kd for irredeemable fixed rate debt
Where i = interest amount per debenture
Example:
A company has issued irredeemable debenture at market value of Rs.100 @12%. Calculate required rate of return Kd.
To calculate Ex Div Share i.e. Po the formula is
Companies shall get tax relief on the interest as well, therefore interest must be after tax.
Formula of Kd after tax for irredeemable fixed rate debt
Example:
A company has value of Rs.30 million of debenture on its balance sheet debt portion. The loan is irredeemable interest rate is 12%. Market value is Rs.90 per 100 debenture. Tax rate is 30%.
Calculate market value of debt and cost of debt.
Solution:
Market value of debt = 30 million x = 90 / 100 = 27 million
Cost of debt :
Redeemable Fixed Rate Debt
The redemption value is agreed at the time of issue and maybe on discount or premium.
How to calculate market value of redeemable fixed rate debt
Example:
A company has issued 14% redeemable debt for 5 years. Redemption shall be at par value. The investor required rate of return is 12%. Calculate current market value of the debt.
Year | Cash flow | Discount 12% | Present value | ||
0 | Market value | 1 | (107.17) | Balancing figure | |
1-5 | Interest | 14 | 3.605 | 50.47 | |
5 | Redemption | 100 | 0.567 | 56.7 | |
NPV | 0 |
Market value of the debt is Rs.107.17.
How to calculate required return on debt Kd for redeemable Fixed Rate Debt
Kd shall be calculated by Internal rate of return (IRR)
Where,
A% = discount rate where NPV is positive (lower discount rate)
B% = discount rate where NPV is negative (higher discount rate)
NPV a = NPV at discount rate A%
NPV b = NPV at discount rate B%
Example:
A company has issued 14% redeemable debt for 5 years. Redemption shall be at par value. Market value of the debt is Rs.107.17 . Calculate investor required rate of return. Tax rate is 30%
Year | Cash Flows | Discount rate 10% | NPV at 10% | Discount rate 15% | NPV at 15% |
0 | (107.17) | 1 | (107.17) | 1 | (107.17) |
1 – 5 | 14 | 3.791 | 53.074 | 3.352 | 46.928 |
5 | 100 | 0.621 | 62.1 | 0.497 | 49.7 |
8.004 | (10.542) |
We shall first calculate investor required rate of return through IRR and then adjusted with tax relief for the company so Kd after tax shall be 12.16 (1-0.30) = 8.512%.
Related Topics
https://theproreaders.com/2021/01/15/internal-rate-of-return-irr/
https://theproreaders.com/2021/01/15/time-value-of-moneycompounding-and-present-value-pv/
Pingback: Time value of money(Compounding and Present Value (PV)) – The Pro Readers