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What is Weighted Average Cost of Capital (WACC)? How does it calculate?


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:
Ke = Rf + b (Rm – Rf)                                       (CAPM method discuss earlier)
= 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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