Weighted Average Cost of

Capital (WACC)
Lec 7
By Prof. Amrit Nakarmi
MSESPM
04 Feb 2020
 Income Statement

Revenue
Costs of Goods Sold (COGS)
Gross Profit
Expenses
Net Income

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Cost of Debt
A firm with a 40% tax rate issues $1,000 bonds at a
face value with coupon rate of 16%. Ignoring
underwriting and issuing expenses,
Market yield (market rate of return) =
rd =160/1000 = 16%
Cost of debt (to the company)=Rd=160*(1-0.4)/1000
=9.6%

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Cost of Debt
If people invest in bonds for long-term, then
Pb =Sum(I/(1+rb)t + F/(1+rb)n

Cost of debt (to the Co)

NPb =Sum(I*(1-Tax)/(1+kb)t + F/(1+kb)n

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Cost of Preferred Share
A corporation issues new $100 preferred shares that
provide $12 in annual dividends. The firm has identical
preferred shares outstanding that also trade at
$100/share. Issuing and underwriting expenses are 5%
of the issue price and assumed to be tax deductible.
The firm’s tax rate is 40%.

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Cost of Preferred Share
Net Proceeds of preferred share (to the Co.) =NPp=100-
(1-0.4)*5 =$97
rp=12/100 =12%
kp=12/97 =12.37% (cost of preferred share
to the Co.)

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Cost of Preferred Share (for long-term
investment)
Pp=Dp*Sum(1/(1+ rp)t)

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Cost of Equity
A corporation issues new $100 common shares that
provide $16 in annual dividends. The firm has identical
common shares outstanding that also trade at
$100/share. Issuing and underwriting expenses are 5%
of the issue price and assumed to be tax deductible.
The firm’s tax rate is 40%.

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Cost of Equity
Net Proceeds of common share (to the Co.) =NPe=100-(1-
0.4)*5 =$97
re=16/100 =16%
ke=16/97 =16.49% (cost of equity to the Co.)

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Cost of Equity (long-term)
Market capitalization rate
Pe=SUM(Dt/(1+ re)t)

Cost of new shares

NPe =SUM(Dt/(1+ ke)t)

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Cost of Equity
Usually cost of equity is not known, then we have to
use Capital Asset Pricing Model (CAPM) to find out
cost of equity.

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Cost of Equity –Capital Asset Pricing
Model(CAPM)
Security market line
Expected
Return

Slope:market price of
return

Cost of Equity (ke) = Rf + Equity Beta

Risk free * (E(Rm ) - Rf)
return
Risk

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Cost of Equity
Cost of Equity (ke) = Rf + Equity Beta * (E(Rm ) - Rf)
where, Rf = Riskfree rate
E(R m) = Expected Return on the Market Index (Diversified
Portfolio)
In practice,
• Short term government security rates are used as risk free
rates
• Historical risk premiums are used for the risk premium
• Betas are estimated by regressing stock returns against
market returns (it shows how much the equity is riskier than
the market)

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Weighted Average Cost of Capital (WACC)
If ‘I’ is the total investment, then
I =B+P+E, where B is borrowing (loans and bonds), P is
preferred shares, and E is equity.
Then,
WACC =Rb(1-Tax)*B/I +kp*P/I + ke*E/I

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Example on WACC
A firm plans on financing major
new expansion programs by
drawing on funds in the
following proportions that
roughly corresponds to its
current capital structure:
Long –term debt $30 mil
Preferred shares $10 mil
New common shares $40 mil
Issuing and underwriting expenses
can be ignored. Debt can be
issued at a coupon rate of 12%,
and the dividend yield on
preferred shares would be 9%.
Common
04/13/2020
Shares currently trade at $45 per
share. The current dividend
yield on preferred shares
would be $2.25 per share.
Management feels that, over
long run, growth in dividend
match inflation rate, which is
anticipated to be 10% per year.
The corporate tax is 40%.
What is the firm’s weighted
average cost of capital (WACC)
?
15
Example on WACC
The current interest on government debt is 10%, and
the return on the market is expected to exceed this rate
by 7%. What value of beta do we have to assume for
the firm if the cost of equity as derived from the CAPM
is to match the Ke =15% calculated according to the
dividend growth model under above example?

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Example on WACC
kb = (1-T) rb =0.6*12% =7.2%
kp = rp =9%
Ke =D1 / pe+g =2.25/45+0.1 = 0.15 or 15%

Source Proportion Cost in % Weighted Cost

Debt 30/80 =0.375 7.2% 2.7%

Preferred 10/80 =0.125 9% 1.13%

Common 40/80 =0.50 15% 7.5%

WACC = 2.7% +1.13% +7.5% =11.33%

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Example on WACC
A firm plans on financing major
new expansion programs by
drawing on funds in the
following proportions that
roughly corresponds to its
current capital structure:
Long –term debt $30 mil
Preferred shares $10 mil
New common shares $40 mil
Issuing and underwriting expenses
can be ignored. Debt can be
issued at a coupon rate of 12%,
and the dividend yield on
preferred shares would be 9%.
Common
04/13/2020
Shares currently trade at $45 per
share. The current dividend
yield on preferred shares
would be $2.25 per share.
Management feels that, over
long run, growth in dividend
match inflation rate, which is
anticipated to be 10% per year.
The corporate tax is 40%.
What is the firm’s weighted
average cost of capital (WACC)
?
18
Example on WACC
The current interest on government debt is 10%, and
the return on the market is expected to exceed this rate
by 7%. What value of beta do we have to assume for
the firm if the cost of equity as derived from the CAPM
is to match the Ke =15% calculated according to the
dividend growth model under above example?

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Assignments
Chapter 6 (page 128)
2, 3 &5.
Chapter 9 (page 215)
3, 8, 12 & 13
Readings for financial statement analysis
Chapter 2: Park’s engineering economics
Chapter 3: Peter Atrill’s book
Chapters 24 & 25: I M Pandey’s book