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Measurement of weighted average cost of capital WACC

Measurement of weighted average cost of capital WACC. It is also called as Overall Cost of Capital .

bradley-summers
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Measurement of weighted average cost of capital WACC

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  1. Measurement of weighted average cost of capitalWACC It is also called as Overall Cost of Capital . Weighted average cost of capital is the expected average future cost of funds over the long run found by weighting the cost of each specific type of capital by its proportion in the firms capital structure. The computation of the overall cost of capital (Ko) involves the following steps. (a) Assigning weights to specific costs. (b) Multiplying the cost of each of the sources by the appropriate weights. (c) Dividing the total weighted cost by the total weights.

  2. WACC The WACC can be calculated with the help of the following formula; Ko= Kd Wd + Kp Wp + Ke We + Kr Wr Where, Ko = Overall cost of capital Kd = Cost of debt Kp = Cost of preference share Ke = Cost of equity Kr = Cost of retained earnings Wd= Percentage of debt of total capital Wp = Percentage of preference share to total capital We = Percentage of equity to total capital Wr = Percentage of retained earnings Kw = Σ XW ÷ Σ W Where, Kw = Weighted average cost of capital X = Cost of specific sources of finance W = Weight, proportion of specific sources of finance.

  3. WACC Exercise A firm has the following capital structure and after-tax costs for the different sources of funds used : Compute the weighted average cost of capital

  4. Solution Kw = Σ XW ÷ Σ W Kw = 4590 ÷ 60000 = 9.15%

  5. Exercise ABC Ltd. has the following capital structur Equity (expected dividend 12%) $.1000,000 10% preference 5,00,000 8% loan 15,00,000 required : calculate the weighted average cost of capital, assuming 40% as the rate of income-tax, before and after tax. • Solution • Solution showing weighted average cost of capital: Weight average cost of capital =8.05%

  6. ADJUSTING THE WEIGHTED AVERAGE COSTOF CAPITAL FOR RISK • The procedure for adjust the company’s WACC for risk follows: 1. Estimate the company’s expected WACC during the life of the project. 2. Extract the company’s risk premium from its WACC. 3. Calculate the company’s risk premium to reflect the relative risk of the project (or of its risk class). 4. Adjust the WACC for the difference between the project’s risk premium and the company’s risk premium.

  7. 2. Extract the company’s risk premium from its WACC. A company’s WACC already reflects its weighted average risk premium. In theory, we could extract the value of the weighted average risk premium simply by subtracting the risk-free rate from the WACC. Risk premium = market risk – risk free . Weighted Average Risk Premium = WACC - Cost of Debt After Tax Cost of Debt After Tax is the credit risk premium (or Risk premium)is the additional interest above the risk-free rate that the company must pay to compensate lenders for the possibility that the company might default on its payments to lenders.

  8. ADJUSTING THE COMPANY’S RISK PREMIUMFOR PROJECT RISK THE RELATIVE RISK FACTOR We can do so by multiplying the company’s risk premium by a measuring factor Fj adjusting the company premium for the relative risk of Project j: Risk Premium for Project j = Fj × Company Risk Premium ADJUSTING THE WACC FOR THE PROJECT’S RISK PREMIUM We obtain the risk-adjusted WACC for a project or for its risk class simply by adding to the company’s expected WACC the difference between the project’s risk premium and the company’s risk premium:

  9. ADJUSTING THE COMPANY’S RISK PREMIUMFOR PROJECT RISK Adjusted WACC + project risk =ًProject Risk Premium - Company Risk Premium The resulting risk-adjusted WACC provides discount rates reflecting the differing risks of the company’s projects.

  10. The company requires a discount rate to help it to evaluate one of its proposed networking systems. The following data are potentially relevant: Growth rate 100% Dividend yield 0 Equity beta 1.60 Expected risk premium on the market 4% Expected risk-free rate on equity 5% Expected borrowing rate 7% Target proportion of debt financing 60% Corporate tax rate 30% Relative risk factor for project (Fj) 1.20 1. Estimate the company’s WACC for

  11. ANALYSIS 1. Estimate the company’s WACC for the life of the project. First, we estimate the costs of debt and equity for the WACC. Cost of debt Cost of Debt After Tax = 7 (1- 0:30/ (1-1.07 )0.25 = 4.94% This calculation assumes a three-month delay in the payment of Corporation Tax at 30%, thus discounted at 7% for 0.25 years. Cost of equity. The IRR on the dividend stream would give a nonsense answer for the cost of equity for two reasons. First, the company pays no dividends currently. Second, even if the company were to be paying dividends, its 100% growth rate is much too large relative to the growth rate of the economy. Thus, we use the CAPM instead: Cost of Equity = Risk-free Rate + Equity Beta × Market Risk Premium %4 = 11.4% = 5% +1.6 × We can now calculate the expected WACC for the company: WACC = W × Expected Cost of Debt After Tax + W ×Expected Cost of Equity = 60% × 4:94% + 40% × 11.4% =7.52%

  12. 2. Obtain the company’s risk premium Company Risk Premium = WACC - Cost of Debt After Tax = %7.52 - %4.94 = 2.58% 3. Adjust the company’s risk premium to obtain the risk premium for the project or for its risk class Risk Premium for Project j = Fj ×Company Risk Premium = 1.20 ×2.58% = 3.10% • 4. Adjust theWACC for thedifference between the project’s risk premium and the company’s risk premium • Adjusted WACC = WACC +(project risk premium – company risk premium • =7.52% + (3.10% - 2.58%) =8.04%

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