CALCULATION OF WEIGHTED AVERAGE COST OF

CAPITAL

By the end of this Lecture 21 April 2020, you should be able to:
1. Calculate WACC using Book Values and Market Values
 COST OF CAPITAL
• The cost of capital is the marginal cost which is the cost of raising additional capital.
• It may not be same cost that was incurred in the past because of changes in the financial markets and in
the business environment.
• For example general economic conditions affect interest rates; market conditions affect risk premiums;
operating decisions affect business risk; financial decisions affect financial risk; and amount of financing
affect flotation costs and market price of securities.
• The cost of debt is represented by kd
• The cost of preferred equity is represented by kp
• The cost of common equity is represented by Kr (retained earnings) or ke (cost of raising new ordinary
equity)
• In financing businesses, managers have different preferences of the sources. Some prefer more debt and
less equity and preference equity, others prefer the opposite, etc. Thus different companies have different
weights of capital sources in their balance sheets.
• Some companies also have a target or optimal capital structures that they strive to achieve.
• Consequently, to get the weighted average cost of capital (WACC), the individual costs of capital are
multiplied by the respective weights representing the proportion of each source of financing that is used.
- WACC is also known as the marginal cost of capital (MCC).
WACC FORMULA
WACC = wdkd (1 − t) + wpkp + wekeor kr

where
wd is the proportion of debt that the company uses when it raises new funds
kd is the before-tax marginal cost of debt
t is the company’s marginal tax rate
wp is the proportion of preferred stock the company uses when it raises new funds
kp is the marginal cost of preferred stock
we is the proportion of equity that the company uses when it raises new funds
ke is the marginal cost of equity
Kr is the cost of internal equity or retained earnings

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STAGES OF WACC CALCULATION
▪ When calculating the Weighted average cost per capital we use the following procedure :
▪ · Calculate the cost of each component of capital,
▪ · Calculate the weight of each component,
▪ · Multiply the cost of each component by the respective weight and add the total.

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PRACTICE EXAMPLE
A firm has the following market values on its balance sheet :
• Debt $4,000
• Ordinary equity $12, 000
• Preferred equity $4,000
Calculations showed that cost of debt was 8.08%, cost of preferred equity 10% and Cost of Equity was
16.4%
Calculate WACC.
Answer
Market Values Weights(1) Cost of Capital (2) WACC (1 x 2)
Debt $4,000 20% (4000/20000 8.08% 1,62%
Preferred Equity $4, 000 20% (4000/20000 10% 2%
Ordinary Equity $12,000 60% (12000/20000) 16.4% 9.84%
Total $20, 000 100% 13.46%

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PRACTICE QUESTION
• FK (Pvt) Ltd has asked you to help management to determine the cost of financing the company. Relevant extracts from the most recent
Statement of Financial Position as at 30th November 2019 are as follows:
• Equity $[millions]
• Ordinary Shares of $0.50 each 2.0
• Retained Earnings 1.5
• Non-Current Liabilities
• 7.5% Redeemable Debentures of $1000 each 2.2
• 6% Irredeemable Preference Shares of $100 each 1.4
7.1
• The following additional information is relevant:
• FK (Pvt) Ltd’s ordinary shares are currently trading at $2.60 cum-div per share and $2.00 ex div per share. The most recent dividend just
declared will be paid in the next 5 working days. Since the company’s product lines are now predominantly in their decline stage in
accordance with the Product Life Cycle (PLC) Model, the Board of Directors has seen it fit to reduce the annual dividend per share by 5%
per annum forever, starting with the forthcoming financial year ended 30th November 2020. Debentures are presently valued at 10%
below their par value and will be redeemed on the 30th November 2026. Preference shares are trading at 20% above their par value. The
prevailing corporate tax rate is 25.75%.
• REQUIRED
• (a) Calculate FK (Pvt) Ltd’s Weighted Average Cost of Capital (WACC) using the following weighting bases:
• (i) Book values [7]
• (ii) Market values [10]
• (b) Which weighting base is superior and why? [4]
• (c) Explain any four factors that influence a company’s weighted average cost of capital (WACC). [4] (refer to your notes).

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 ANSWER
Source of capital Book values Market Values Cost of Capital

Equity Pick from SOFP [Ordinary Share Capital VE = Po*number of ordinary shares Using Constant Dividend Growth
+ All Reserves] = 2*2m/0.5 Ke = Do(1+g)/Po + g
= 2m+1.5m = $3.5m =2*4m = 0.60(1-0.05)/2.00 – 0.05
= $8m = .57/2 -0.05
=23.5%

Preference Share Capital Pick from SOFP VP = Po*number of preference shares Irredeemable
=$1.4m =120*1.4m/100 Kp = d/Po
=120*14000 = 6/120
=$1.68m = 5%

Debentures Pick from SOFP VD = Po*number of debt units Redeemable

=$2.2m =900*2.2m/1000 Kd = [75 + [1000-900]/7]
=900*2200 [(1000+1800)/3]
=$1.98m =89.285714286/933.33
= 9.56632653%

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USING BOOK VALUES AND MARKET VALUES
• Using Book Values WACC
𝑉𝐸 𝑉𝐷 𝑉𝑃
• = [ 𝑉𝐸+𝑉𝐷+𝑉𝑃][Ke] +[ 𝑉𝐸+𝑉𝐷+𝑉𝑃][Kd(1-t)] + [𝑉𝐸+𝑉𝐷+𝑉𝑃][Kp]
3,500,000 2,200,000 1,400,000
• =[ 7,100,000][0.235] +[ 7,100,000][0.0956632653(1-0.2575)] + [7,100,000][0.05]
• = = 0.4929577465*0.235 + 0.3098591549*0.095663*0.7425 + 0.1971830986*0.05
• = 0.1158450704 + 0.0220092879 + 0.0098591549
• = 14.771%
•
• Using Market Values WACC
𝑉𝐸 𝑉𝐷 𝑉𝑃
• = [ 𝑉𝐸+𝑉𝐷+𝑉𝑃][Ke] +[ 𝑉𝐸+𝑉𝐷+𝑉𝑃][Kd(1-t)] + [𝑉𝐸+𝑉𝐷+𝑉𝑃][Kp]
8,000,000 1,980,000 1,680,000
• =[ 11,660,000][0.235] +[ 11,660,000][0.0956632653(1-0.2575)] + [11,660,000][0.05]
• = 0.6861063465*0.235 + 0.1698113208*0.095663*0.7425 + 0.1440823328*0.05
• = 0.1612349914 + 0.0120616938 + 0.0072041166
• = 18.05%
•

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WHY ARE MARKET VALUES PREFERRED THAN BOOK VALUES
• The market value of equity is a measure of the value of the shareholders' investment in the corporation.
The total market value of all shares outstanding represents the market value of the entire corporation.
• The book value of equity represents the net assets, or total assets less total liabilities, as recorded in the
balance sheet.
• Market values constitute the superior basis of weighting in calculating WACC because of the following:
• Market values are futuristic, reflecting the firm’s growth potential, while book values are historical
• Market values arise as a result of independent valuation by capital markets while book values are
influenced by a firm’s accounting policies such as depreciation, share valuation, doubtful; debts provisions,
etc and are also susceptible to earnings management or window dressing
• In an inflationary environment, book values tend to be outdated and does not show a true reflection of the
value of the shares.