Weighted average cost of capitalWeighted average cost of capital

The The weighted average cost of capital (WACC)weighted average cost of capital (WACC) is the rate that is the rate that a company is expected to pay on average to all its security a company is expected to pay on average to all its security holders to finance its assets.holders to finance its assets.The WACC is the minimum return that a company must earn on The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies providers of capital, or they will invest elsewhere. Companies raise money from a number of sourcesraise money from a number of sources: : common equitycommon equity, , preferred equitypreferred equity, straight , straight debtdebt, , convertible debtconvertible debt, , exchangeable exchangeable debtdebt, , warrantswarrants, , optionsoptions, , pension liabilitiespension liabilities, , executive stock executive stock optionsoptions, governmental subsidies, and so on. Different securities, , governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into generate different returns. The WACC is calculated taking into account the relative weights of each component of the account the relative weights of each component of the capital capital structurestructure. The more complex the company's capital structure, . The more complex the company's capital structure, the more laborious it is to calculate the WACC.the more laborious it is to calculate the WACC.

CalculationCalculation

In general, the WACC can be calculated with the In general, the WACC can be calculated with the following formula:following formula:

Where:Where: NN is the number of sources of capital is the number of sources of capital (securities, types of liabilities); (securities, types of liabilities); rrii is the required rate of return for security is the required rate of return for security ii; ;

MVMVii is the market value of all outstanding securities is the market value of all outstanding securities ii..

Tax effects can be incorporated into this formula. For Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one example, the WACC for a company financed by one type of shares with the total market value of type of shares with the total market value of MVMVee and and

cost of equity cost of equity RRee and one type of bonds with the total and one type of bonds with the total

market value of market value of MVMVdd and cost of debt and cost of debt RRdd, in a country , in a country

with corporate tax rate with corporate tax rate tt is calculated as: is calculated as:

Capital Structure of Corporations Capital Structure of Corporations

Corporations need money daily to finance their operating Corporations need money daily to finance their operating activities, embark on investment activities and pay taxes, interest activities, embark on investment activities and pay taxes, interest expense, etc. Corporation can raise capital in two ways:expense, etc. Corporation can raise capital in two ways:

1) Bonds (debt financing)1) Bonds (debt financing)2) Issue common and preferred shares2) Issue common and preferred shares

What if a corporation does both of these? It can issue bonds What if a corporation does both of these? It can issue bonds (which are a source of debt) and more common shares (which is (which are a source of debt) and more common shares (which is a source of equity). But what's the right mix between the two? a source of equity). But what's the right mix between the two? How much debt and how much equity should a company carry? How much debt and how much equity should a company carry? We answer this question next:We answer this question next:

Note: The mix of bonds (debt) and common shares of a Note: The mix of bonds (debt) and common shares of a corporation is known as its Capital Structure. corporation is known as its Capital Structure.

The amount of debt and equity that a company must maintain can The amount of debt and equity that a company must maintain can be calculated via the WACC. be calculated via the WACC.

Weighted Average Cost of Capital (WACC) is therefore an Weighted Average Cost of Capital (WACC) is therefore an overall return that a corporation MUST earn on its existing overall return that a corporation MUST earn on its existing assets and business operations in order to increase or assets and business operations in order to increase or maintain the current value of the current stock. For maintain the current value of the current stock. For example, if Microsoft's WACC is 15% and current stock example, if Microsoft's WACC is 15% and current stock price is 28$, then the company must earn a 15% return on price is 28$, then the company must earn a 15% return on its existing assets and business operations (net income) in its existing assets and business operations (net income) in order to MAINTAIN the stock price at $28. The last thing order to MAINTAIN the stock price at $28. The last thing that corporations would wish to happen is their stock price that corporations would wish to happen is their stock price falling down!falling down!

Example:Example:Coco Corp. has issued 10,000 units of bonds that are currently selling at Coco Corp. has issued 10,000 units of bonds that are currently selling at 98.5. The coupon rate on these bonds is 6% per annum with interest paid 98.5. The coupon rate on these bonds is 6% per annum with interest paid semi-annually. The maturity left on these bonds is 3 years. The company semi-annually. The maturity left on these bonds is 3 years. The company has 2,000,000 common shares outstanding with the current stock price at has 2,000,000 common shares outstanding with the current stock price at $10 / share. The stock beta is 1.5, risk free rate for government bonds is $10 / share. The stock beta is 1.5, risk free rate for government bonds is 4.5% and the Expected Return on the Stock Market is 14.5%. The tax rate 4.5% and the Expected Return on the Stock Market is 14.5%. The tax rate for the corporation is 30%.for the corporation is 30%.

Bond Calculations Stock Calculations

N = 3 x 2 = 6I/Y = ? (Rd)PV = 0.985 x 10,000 x $1000 = $9,850,000 (D)PMT = (-10,000,000 x 0.06) / 2 = $-300,000FV = $-10,000,000P/Y = 2C/Y = 2Solution: I/Y = 6.56%

Re = Rf + B[Rm - Rf]Re = 0.045 + 1.5 [0.145 - 0.045]Re = 0.045 + 0.15 = 0.195 (19.5%)Market Value of Equity = EStock price x common shares O/S$10 x 2,000,000 = $20,000,000

V = Total Capital StructureV = Total Capital StructureV = 9,850,000 (bonds debt) + 20,000,000 (equity of common V = 9,850,000 (bonds debt) + 20,000,000 (equity of common shares)shares)V = 29,850,000V = 29,850,000

Summary of Important TermsSummary of Important Terms Rd = 6.56% = 0.0656Rd = 6.56% = 0.0656D = 9,850,000D = 9,850,000V = 29,850,000V = 29,850,000D/V = 9,850,000 / 29,850,000D/V = 9,850,000 / 29,850,000Re = 0.195Re = 0.195E = 20,000,000E = 20,000,000E/V = 20,000,000 / 29,850,000 = 0.67E/V = 20,000,000 / 29,850,000 = 0.67(1-T) = (1 - 0.3) = 0.7(1-T) = (1 - 0.3) = 0.7

WACC = [Rd x D/V x (1-5)] + [Re x E/V]WACC = [Rd x D/V x (1-5)] + [Re x E/V] = [(0.0656) (0.33) (0.7)] + [(0.195) (0.67)]= [(0.0656) (0.33) (0.7)] + [(0.195) (0.67)]= 0.01515 + 0.1307 = = 0.01515 + 0.1307 = 0.1458 0.1458 of WACCof WACC-> 14.58%-> 14.58%

INTERPRETATIONINTERPRETATION

A WACC of 14.58% means Coco Corp. must earn a A WACC of 14.58% means Coco Corp. must earn a return of 14.58% on all its assets and business return of 14.58% on all its assets and business operations in order to MAINTAIN the current stock operations in order to MAINTAIN the current stock price at $10 per share. If Coco Corp. wants greater price at $10 per share. If Coco Corp. wants greater than its stock price to go higher, it must achieve a than its stock price to go higher, it must achieve a return rate 14.58%return rate 14.58%

  Cost of equityCost of equity

Cost of equity is the return (often expressed as a rate of Cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors return) a firm theoretically pays to its equity investors such as shareholders to obtain their capital. Firms need such as shareholders to obtain their capital. Firms need to acquire capital from others to operate and grow. to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital Just as landlords seek rents on their property, capital providers seek returns on their funds.providers seek returns on their funds.

CalculationsCalculations::

Cost of equity = Risk free rate of return + Premium expected for riskCost of equity = Risk free rate of return + Premium expected for riskCost of equity = Risk free rate of return + Beta x (market rate of return- Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) Where Beta= sensitivity to movements in the risk free rate of return) Where Beta= sensitivity to movements in the relevant market: relevant market:

Where:Where:EEss, The expected return for a security, The expected return for a security

RRff, The expected risk-free return in that market (government , The expected risk-free return in that market (government

bond yield) bond yield)ββss, The sensitivity to market risk for the security, The sensitivity to market risk for the security

RRMM, The historical return of the stock market/ equity market, The historical return of the stock market/ equity market

(R(RMM-R-Rff)), The risk premium of market assets over risk free assets., The risk premium of market assets over risk free assets.

The risk free rate is taken from the lowest yielding bonds in The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds. the particular market, such as government bonds.

Expected returnExpected return::

The expected return (or required rate of return for investors) can be The expected return (or required rate of return for investors) can be calculated with the "calculated with the "dividend capitalization modeldividend capitalization model", which is", which is

CommentsComments::

The models state that investors will expect a return that is the The models state that investors will expect a return that is the risk-risk-free returnfree return plus the security's sensitivity to plus the security's sensitivity to market riskmarket risk times the times the market risk premium.market risk premium.

The risk premium varies over time and place, but in some The risk premium varies over time and place, but in some developed countriesdeveloped countries during the twentieth century it has averaged during the twentieth century it has averaged around 5%. The equity market real capital gain return has been around 5%. The equity market real capital gain return has been about the same as annual real GDP growth. The capital gains on about the same as annual real GDP growth. The capital gains on the Dow Jones Industrial Average have been 1.6% per year over the Dow Jones Industrial Average have been 1.6% per year over the period 1910-2005. The dividends have increased the total the period 1910-2005. The dividends have increased the total "real" return on average equity to the double, about 3.2%."real" return on average equity to the double, about 3.2%.

The sensitivity to market risk (β) is unique for each firm and The sensitivity to market risk (β) is unique for each firm and depends on everything from management to its business and depends on everything from management to its business and capital structurecapital structure. This value cannot be known ". This value cannot be known "ex anteex ante" " (beforehand), but can be estimated from (beforehand), but can be estimated from ex postex post (past) returns and (past) returns and past experience with similar firms.past experience with similar firms.

Cost of retained earnings/cost of internal equity:Cost of retained earnings/cost of internal equity:

Note that Note that retained earningsretained earnings are a component of equity, and are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. Dividends (earnings that are the cost of equity as explained above. Dividends (earnings that are paid to investors and not retained) are a component of the return paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital on capital to equity holders, and influence the cost of capital through that mechanism.through that mechanism.

Cost of debt:Cost of debt:

The cost of debt is computed by taking the rate on a The cost of debt is computed by taking the rate on a risk free bondrisk free bond whose duration matches the whose duration matches the term structureterm structure of the corporate debt, of the corporate debt, then adding a then adding a default premiumdefault premium. This default premium will rise as the . This default premium will rise as the amount of debt increases (since, all other things being equal, the amount of debt increases (since, all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt risk rises as the amount of debt rises). Since in most cases debt expense is a expense is a deductible expensedeductible expense, the cost of debt is computed as , the cost of debt is computed as an after tax cost to make it comparable with the cost of equity an after tax cost to make it comparable with the cost of equity (earnings are (earnings are after-taxafter-tax as well). Thus, for profitable firms, debt is as well). Thus, for profitable firms, debt is discounteddiscounted by the tax rate. The formula can be written as by the tax rate. The formula can be written as

(Rf + credit risk rate)(1-T)(Rf + credit risk rate)(1-T), ,

where T is the corporate tax rate and Rf is the risk free rate.where T is the corporate tax rate and Rf is the risk free rate.

REASONREASON::

* If the cost of components high the weighted average cost of capital* If the cost of components high the weighted average cost of capital increases and reason is that shareholder prefer to use of debt increases and reason is that shareholder prefer to use of debt when expected value of tax benefit is attractive as compared to when expected value of tax benefit is attractive as compared to the added financial risk associated with the debt. the added financial risk associated with the debt.

* The cost of equity and debt increases with the increase in debt.* The cost of equity and debt increases with the increase in debt.

* The Demanded rate of increase in cost of debt and equity, effects* The Demanded rate of increase in cost of debt and equity, effects on value of the expected increase in tax benefit of using more on value of the expected increase in tax benefit of using more debt. debt.

* Equity financing cannot create a tax advantage because dividends* Equity financing cannot create a tax advantage because dividends are paid after interest and tax. are paid after interest and tax.

* Debt financing becomes attractive when tax is deductable from * Debt financing becomes attractive when tax is deductable from interest. interest.

RECOMMENDATION:RECOMMENDATION:

Cost of capital become low that could lower by the management in Cost of capital become low that could lower by the management in down market through viewing current corporate governance down market through viewing current corporate governance themes, taking action on giving management training with respect themes, taking action on giving management training with respect to capital market issues of today and advanced planning to identify to capital market issues of today and advanced planning to identify the potential investors.the potential investors.