Back to basics: weighted average cost of capital

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By Rachel Norman, lecturer

22 April 2019

Are you familiar with the weighted average cost of capital? The calculation of a company’s cost of capital appears in Module 12 of the TC Finance course, and we go back to basics on the formulas.

In order to operate and grow, companies need to raise finance, often from numerous sources, such as bank loans or share issues. Financing rarely comes for free; investors will expect a return on their investment.

The return demanded by investors is a cost to a company, called the cost of capital. This is expressed as a percentage and can be calculated as a weighted average of the different finance costs held by a company.

Looking at a company with both debt and equity financing in its capital structure, it is possible to calculate its weighted average cost of capital (‘WACC’) as follows:

where:

%d = proportion of debt capital to total capital

%e = proportion of equity capital to total capital

kd = cost of debt

ke =  cost of equity

It is important that market values are used wherever possible, both in the calculation of the weighting percentages and within the cost calculations.

Cost of equity

Investors in a company’s ordinary share capital will expect their return to come in the form of dividends and/or capital appreciation. The following formula can be used to calculate the cost of equity:

where:

D = most recent historic dividend

g = growth rate in dividends

P = ex-div market price of the share

Cost of debt reminder

Irredeemable debt:

While there are several different forms of debt financing available to a company, in TC Finance we consider debt most often in the form of bonds or debentures. The calculation of the cost of debt for a company depends on whether the debt is redeemable or irredeemable, with the cost of irredeemable debt calculated using the following formula:

where:

t = corporate tax rate

I = Interest payable

MV ex int = ex-interest market value of the debt

Redeemable debt:

Redeemable debt requires a different calculation, as investors will receive interest payments over the life of the debt but will also receive a capital amount when the bonds are redeemed. This redemption may be at the par or face value of the bonds, or at a discount or premium.

The overall return to an investor, equivalent to the cost of redeemable debt to a company, can be calculated as the internal rate of return (‘IRR’) of the cashflows associated with the bonds.

The WACC formula can be expanded to include other types of capital a company has in place, such as preference shares, but this falls outside the scope of the TC Finance course.

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