Explain what weighted average cost of capital (WACC) is, and explain its constituents. Provide verbal and symbolic explanations.
Add a fictitious example for better clarification Explain in your example how expected rate of return is evaluated, is it based on an unleveraged beta or leveraged beta.
Also, include your assumptions on risk free rate of return and market portfolio rate of return in evaluating expected rate of return.
Introduction
Weighted Average Cost of Capital (WACC) is the rate for the return that organizations pay to their investors. In other words, it is the cost, which a company bears to raise fund. In simple words as defined earlier that it is the average rate of the return, which an organization is expected to compensate all of its investors. The weights specifically are the portion or part of the specific type of financing source for the company has targeted capital structure. The sources of capital can be formed Equity financing, through preferred stocks or by debt financing or lenders. These specific sources are given weights as per its specific weight in relative to the target capital structure. Each of the component or source of funding has a different cost. Thus, for computing the cost of the total capital source, the weighted average is computed (Lasher, 2016).
Constituents
For the evaluation of WACC, the formula of WACC is used, following are the components, which constitute it:
1-Cost of equity (COE):
The Equity has also cost. It is constituted by the part of the financing, which is being done by investing in equity or stocks. The cost of Equity can be calculated through the CAPM model. BY this model, the cost of equity is equal to:
Cost of Equity(Ke)=Rf+(B*(Rm-Rf))
Here;
Rf: is estimated Risk-Free return
Rm: is previous return of market
B: can be defined as market risk
2-Risk-Free Return:
The risk-free return is the hypothetical or an ideal rate on any investment if it has zero risks. Generally, for the computation of cost of equity, the yield on a ten-year government bond can be used. Other than this, the rate on the Treasury bill can be recognized as risk-free rate of return (Lasher, 2016).
3-Beta:
The Beta is computed for evaluating the riskiness and instability in the stock in comparison with the market. A beta value of less than 1 shows lower risk than the market, and higher than 1 shows the higher risk stock than the market.
4-Cost of Debt:
Cost of debt is the cost that an organization has borrowed funds from any financial institution. This cost represents the debt potion cost of capital. In the cost of the principal debt component is the interest which is compensated with the effect of the tax rate (Lasher, 2016).
Cost of Debt (Kd)=Inteerst Rate(1-tax rate)
5-Market Return:
The market return is the estimated rate of a portfolio or stock currently represented or trading in the market. The S&P 500 index 52-week return can be used as the return of a market for any invested trading in the index. The market return less the risk-free return gives the market premium value.
6-Cost of Preferred Shares:
The cost that is associated with preferred shares is calculated by the dividend-paying rate.
Cost of Preferred Share (Kp)=Divdiend Rate
7-Tax Rate:
The tax rate is the income tax rate which the company is paid on its income generated from its business activities. This is used to deduct the effect of tax rate on the cost of debt.
Example
For understanding the computation of cost of capital; let us take an example of a company whose details are as follows (Yahoo Finance, 2017):
| Kp | 15.00% | assumed |
| Int Rt | 10.00% | assumed |
| tax rate | 30.00% | assumed |
| Risk-Free Rate | 1.22% | (^IRX 13 week T-bill) |
| Market Rate of return | 19.15% | (^GSPC 52 week Range) |
| Beta | 1.20 | assumed |
For the computation of the Cost of Preference shares it is equal to dividend rate, hence;
Kp=15%
For the computation of Cost of Equity:
Ke=(1.22%+1.20(19.15%-1.22%)
Ke=22.74%
For the computation of Cost of debt:
Kd=10%(1-30%)
Kd=7%
The weights of the sources of financing are assumed as:
| Source of financing | Weight |
| Equity | 30% |
| P.Shares | 30% |
| Debt | 40% |
| Total | 100% |
This gives us the computation for WACC, which is done by this formula:
WACC=(Weight of Equity×Ke)+(Weight of P.Shares×Kp)+(Weight ofDebt×Kd)
WACC=(30%×22.74%)+(30%×15%)+(40%×7%)
WACC=14.12%
WACC shows that if a company can earn more than the WACC rate than it will have positive future cash flows and it can accept the project. Moreover, WACC considers both the levered and the unlevered beta. However, while computing the expected rate of return, we only use the unlevered beta, as it aids in distinction the fact that equity is less risky than debt.
Assumptions
As mentioned earlier, the risk-free return is assumed to be the long-term 10-year yield government bond yield or the rate on the Treasury bill can also be recognized as the risk-free rate of return. For the market rate of return the S&P 500 index 52-week return is assumed as market return.
References
Lasher, W. R. (2016). Practical Financial Management. Cengage Learning .
Yahoo Finance. (2017, November 28). S&P 500 index. Retrieved from Yahoo Finance: https://finance.yahoo.com/quote/%5EGSPC?p=%5EGSPC
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