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Weighted Average Cost of Capital

The weighted average cost of capital is a company’s cost of capital in which each category of capital (such as equity, debt, preference share etc) is proportionately weighted. In a real case scenario, we have two major components in our capital structure i.e., debt and equity. Thus, eventually only debt and equity constitute to the weighted average cost of capital.

WACC acts as a hurdle rate against which investors and companies determine the performance of the return on invested capital. It is ideally used as the discounting factor in case of DCF valuation and is used to compute the net present value of all the free cash flows which a firm generates. In the real case, WACC should be either equal to or greater than the required rate of return, as it portrays a positive image of a company’s overall growth prospects and its profitability.

WACC = (Cost of Equity*Weight of Equity) + (Cost of Debt*Weight of Debt)

Weighted average cost of capital is calculated using

1. Cost of Debt

2. Cost of Equity

3. Weight of Debt

4. Weight of Equity

Cost of Debt

Cost of Debt is the effective rate of interest that a company pays on its debts. Cost of debt includes both short term loans and long-term loans along with bonds and other short-term obligations. The cost of debt eventually refers to before-tax cost of debt i.e., it doesn’t account for the taxes.

Thus, after-tax cost of debt is equal to the effective interest paid on the company’s debt less any taxes due to the tax-deductible advantage of the interests’ payment.

Interests have a tax-deductible advantage because if a company has debt in its capital structure, it is liable to pay interest on that. But when interest is paid, net profit decreases and due to reduced profit less tax is liable to be paid.

For example,

If cost of debt is 10% and tax rate is 30%.

Thus, due to presence of interest, our tax will reduce by 10%.

Therefore, after-tax cost of debt is equal to

After tax cost of debt = Interests – Interests*Tax Rate

After tax cost of debt = Interests*(1-Tax Rate)

Cost of Equity

Cost of Equity represents the cost bearded by the company to raise the capital from open market investors. It is the minimum required rate of return that an investor demands if he invests in a company.

Cost of Equity can be calculated using two methods

1. Capital Asset Pricing Model:

CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the estimates made in the calculation (because it uses historical information).

Cost of Equity = Risk Free Rate + Beta*(Expected Market Return – Risk Free Rate)

Risk Free Rate: The return expected from a risk-free investment (if computing the expected return for a US company, the 10-year Treasury note could be used).

Beta: The measure of systematic risk (the volatility) of the asset relative to the market.

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Expected Market Return: This value is typically the average return of the market (which the underlying security is a part of) over a specified period of time (five to ten years is an appropriate range).

1. Gordon Growth model:

Gordon Growth Model takes into account the dividends and its growth in future. The model is computed by focusing on the next period dividends and how is its average growth of dividends that it has been declaring in the past.

Cost of Equity = (Next period Dividends/Growth Rate) + Current Share Price

Next period Dividends: Companies usually announce dividends far in advance of the distribution. The information can be found in company filings (annual and quarterly reports or through press releases).

Growth Rate: The Dividend Growth Rate can be obtained by calculating the growth (each year) of the company’s past dividends and then taking the average of the values.

Current Share Price: The share price of a company can be found by searching the ticker or company name on the exchange that the stock is being traded on, or by simply using a credible search engine.

Weight of Debt and Equity

Weight of Equity is the percentage of equity in the company’s capital structure. It takes into account the current market price of the company’s share and no of outstanding shares.

Weight of Debt is the percentage of debt in a company’s capital structure. It takes into account the short-term obligations and the long-term debts.

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