WACC and Firm Value:

Financing Costs
Short term Debt Interest/ Markup
Long term debt/ Interest/ Mark up/ Cost of Debt = Kd
Lease Financing Lease Rental
Preferred Stock Preferred Dividend Cost of Preferred
Stock = Kp
Common Stock/ Dividend Cost of Common
Ordinary Share Stock = Ke = Kc
Capital

Capital Structure (Green Highlighted)

Capital structure = Long term debt + SE

Cost of Debt = kd = is that cost which arose on borrowing which have to pay by
the business:
Cost of Debt before tax = (Interest Expenses/ Total Long term debt)* 100
= (5000/20000)*100= 25%
Note: As interest expenses are tax adjustable so we compute cost of debt after
tax

Cost of Debt After tax = Kdbefore tax x ( 1- tax)

Suppose tax rate = 40% = 0.40
Cost of debt after tax = 25 x ( 1-0.40) = 15%

Example to understand the Tax adjustability for interest payments

 Sales 100,000
Less CGS 70,000
GP 30,000
Less OE 15,000
EBIT 15,000
Less Interest 3,000
EBT 12,000
Less tax (0.40) 4,800
EAT 7,200

If
Sales 100,000
Less CGS 70,000
GP 30,000
Less OE 15,000
EBTI 15,000
Less tax (0.40) 6000
EATI 9,000
Less interest 3000
EAT 6000

Benefit from tax adjustability = 6000-4800 = 1200

If borrowing were through Bonds/ Debentures
1. Bonds having Maturity
Bonds Value = Maturity Value x (PVIFkd,n)
2. Bonds Having maturing and Coupon interest Rate
BV = Interest payment x (PVIFA kd,n) + Maturity Value x (PVIFkd,n)
Kd = [I +( BV+MV)/2] /[(BV –MV)/n]
3. Bonds Having Coupon interest rate but no Maturity
BV = I/kd
Kd = I/BV
Cost of Preferred Stock = kp = (Preferred dividend/ Value of Preferred stock )
x100
Exercise:
DPS (dividend per share) of preferred stock is Rs = 2 per share and the value of
preferred stock is = 50
Kp = (Dp/ Vp)= (2/50)x 100= 4%
Cost of Common Stock = Ke = (Dividend/ Value of Common stock )x 100
Dividend = 50000 and value of common stock = 250000
Ke = (50000/250000)x100 = 20%

The other methods that can be used to compute the cost of equity

Dividend Growth models

1. Zero growth model
Value of common stock = Ve= De/Ke
Ke = De/Ve
2. Constant Growth model
Ve = De/ (ke –g)
Ke = (De/Ve )+ g
Capital Asset Pricing model
Ke = Rf + b(Rm-Rf)
Computation Table of WACC

1 2 3 4 = 2x3
Financing Value Weights Costs(%) WACC
Debt 20000 0.0625 15 0.93
Pr stock 50000 0.15625 4 0.625
Common stock 250000 0.780 20 15.6

Total 320000 1.00 WACC = 17.15%

How to compute weight = debt/ Total = 20000/320000 =
0.0625
Weight of Preferred stock = 50000/320000 = 0.15625
Weight of Common stock = 250000/32000 = 0.780
Weights may be computed on the basis of
1. BOOK value weights
2. Market value Weights
3. Target value weights

WACC computation formula

WACC = (Wd X kd) + (Wp X kp)+ (We+ Ke)
WACC = Kd x [Debt/( Debt+PS+CS)]+ Kp
x[PS/(Debt+PS+CS)] + Ke x[ CS//(Debt+PS+CS)
WACC = (0.0625 x15)+ (0.156 X4) + (0.780 X20)
WACC = 17.15%

Value of Firm = [EBIT X(1-tax)]/WACC

Value of firm = [{(Sale-CGS)-OE}x (1-Tax)]/ [Kd x
[Debt/( Debt+PS+CS)]+ Kp x[PS/(Debt+PS+CS)] + Ke
x[ CS//(Debt+PS+CS)]
Example
EBIT = 80000
Tax rate is = 40%
WACC = 17.15% = 0.1715
Value of Firm = 80000 x (1-0.40)/ 0.1715
Value of Firm = 48000/0.1715
Value of Firm = 279883
With 100000 EBIT what will value of firm = 349854

Exercise:
Debt 350000
Preferred stock = 300000
Common Stock =400000
Interest expenses = 45000
Preferred Dividend = 68000
Common Dividend = 70000
EBIT = 550000
Tax rate = 40%
Compute the WACC
Cost of Debt before tax = (45000/350000)x100 =12.85%
Cost of Debt after tax = 12.85 x(1-0.40) = 7.71%
Kp = (68000/300000)x 100 = 22.67%
Ke = (70000/400000)x 100 = 17.5%

Value of Firm = 550000 x (1-0.40)/0.1576

Value of Firm = 330000/0.1576
Value of Firm = 2093909