Finance

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Finance

Weighted Average Cost of Capital

An organization has diverse sources of finance such as the common stock, preferred stock, retained earnings and the debt. WACC stands for the weighted average cost of capital is the average after tax cost of every source of finance by the pertinent credence and adding up the products.

WACC can be calculated using following formula.

Formula

WACC = Weight of equity*Cost of Equity+ Weight of debt*Cost of Debt

For instance, if a company has the one million share outstanding in the common stock and they are currently traded at price of $ 30 per share. The company has prevailing Rf of 4 %, the MRP is 8 % and has the beta of 1.2. The organization has having the bonds of 50,000 along with the 1,000 par paying along with coupon rate of 10 % and maturity is twenty years that are currently traded at $ 950.

The tax rate of the company is 40 %.

Solution

Calculation of Weighted Average Cost of Capital

Weight of Debt and Equity

Market Value of Equity

1000000*30 = 3000000

Market Value of Debt

50000*950 = 47500000

TMV = Market Value of debt and Market Value of Equity

=30000000+47500000 = 77500000

Weight of Equity = 30000000/77500000 = 38.71%

Weight of Debt = 47500000/77500000= 61.29% (It can also be calculated by subtracting weight of equity by 100 %)

Cost of Equity

It can be calculated by using the following formula

Cost of Equity = Rf +(Beta*MRP)

= 4%+1.2*8% =13.6%

The cost of equity = 10.6%

After the tax cost of the debt i.e. 10.6% * (1-0.3) =0.742

WACC = 3.87+1.36+6.12*0.742= 0.98 or 9.8%

For different divisions the different techniques used for the Weighted Average Cost of Capital and potential issues are, for instance of (Vélez-Pareja, 2009) the WACC of the organization is 11.3 % while the division has WACC of 17 % then in the typical projects within the division ...