Weighted Average Cost
of Capital (WACC): It is an average of the total cost of capital raised
through different sources. It includes cost of equity and cost of debt. WACC is
used as investment tool to evaluate investment decision. It is also used as
hurdle rate or discounted rate to calculate NPV. With the help of it Company
can take decision to increase their market value.
It is also helpful for
investors in taking decision to invest in that company or not. If WACC is less
than investors return than it is good for them to invest in some other company.
Formula:
WACC = Ke*E / V + Kd* (1-t)*D / V
OR
WACC = Ke*WE + Kd*
(1-t)*WD
Where,
Ke = required rate of return of equity
E = Market value of equity
D = Market value of Debt
Kd =
Required rate of return of Debt
V = Market value of Debt + Market value of Equity
Example: Suppose
company outstanding equity worth Rs.1, 00,000, outstanding bond worth Rs.5,
00,000 for 20 years and interest rate is 9% and outstanding preferred stock worth of Rs.60,
000 and required rate of return is 8%. The risk free rate is 4%, market return
is 12% and the beta is 1.6. Corporate tax rate is 35%. Find out the weighted average
cost of capital.
Solution:
= 4% + 1.6 (12% - 4%)
Ke =16.8%
E = Rs.1, 00,000
D = Rs.5, 00,000
V = Rs. (1, 00,000 + 5, 00,000 + 60,000)
V = Rs.6, 60,000
WACC = Ke*E / V + Kd* (1-t)*D / V + Kp*P
/ V
= 16.8*1,00,000 / 6,60,000 + 9*(1-0.35)*5,00,000 / 6,60,000
+ 8*60,000 / 6,60,000
= 2.55 + 4.39 + 0.72
= 7.66%
Example: From the
following information determine the weighted cost of capital:
Capital
|
Return %
|
Market Value (Rs.)
|
Debenture
|
8
|
4,00,000
|
Equity
|
6
|
6,00,000
|
Retained earning
|
6
|
1,00,000
|
Solution:
Capital
|
Return %
|
Market Value (Rs.)
|
Debenture
|
8
|
4,00,000
|
Equity
|
6
|
6,00,000
|
Retained earning
|
6
|
1,00,000
|
Total
|
11,00,000
|
WACC = Ke*WE + Kd* (1-t)*WD
+ Kre* WRE
= 6*6,00,000 / 11,00,000 + 8*4.00,000 / 11,00,000 +
6*1,00,000 / 11,00,000
= 3.27 + 2.91 + 0.55
= 6.73%
Example: Company P needs Rs10, 00,000 capital for that
it issues debenture of Rs. 7, 00,000 @11% of Rs. 100 each at Rs.98 for 20 years.
The risk premium is 5%.Company has Rs.2, 00,000 as retained earnings and for
remaining capital it issues equity at the 7%.Find out the WACC if Company pays
40% tax.
Solution:
Cost of Debt:
Kd = (I* + (RV*-SV*) / n) / (RV + SV / 2) (1-t)
= 11 + (100-98) / 20) / (100+98) / 2) (1-0.4)
= 11.1 / 99 (0.6)
=6.72%
Cost of Retained Earnings:
Kre = Kd + RP*
= 11 + 5
= 16%
Cost of Equity = 7%
WACC =Kre*RE / V + Kd*D / V + Ke*E
/ V
= 16*2,00,000 / 10,00,000 + 6.72*7,00,000 / 10,00,000 +
7*1,00,000 / 10,00,000
= 3.2 + 4.704 + 0.7
= 8.60%
*RP = risk premium
*RV = Redemption Value
*SV = Issued Value
*I = interest value
N = number of years
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