Basic Understanding Of Cost Of Capital/Weighted Average Cost Of Capital

May 17th, 2008 Comments off
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Very often, we heard of the terms “cost of capital” and or weighted average cost of capital (WACC) used in maximization of shareholders’ wealth or in the Economic value added methodology.

What is this Cost of Capital or Weighted Average Cost Of Capital?

Firstly let’s look at what’s Cost of Capital:

  • It is the required rate of return that a firm must at least earn to cover the cost of raising funds from its investors namely the debt and equity holders
  • It therefore represents the overall cost of financing to the firm
  • It is always associated with risk in the sense that it is the rate that must be earned by the firm at a given level of risk hence it is normally used as the discount rate in analyzing investments or capital budgeting proposal. In the event the rate of return to be earned from the investment is higher than the firm’s cost of capital, the wealth of the shareholders will then be maximized.

The REASON to know a firm’s cost of capital:-

  • Is because a firm’s cost of capital is the rate of return which links the firm’s investment and its financing decision. Put it simply, if a firm has an overall cost of capital/financing rate of 10% but invested in projects that earned less than 10%, then shareholders’ wealth will be eroded.

Next we move on to Understand the Company’s Weighted Average Cost Of Capital :-

The company’s cost of capital is actually its “weighted average cost of capital (WACC) which is simply

  • The average of the firm’s cost of funds from ALL investors including all types of lenders/debts borrowing and stockholders.
  • This weighted average cost of capital weighs each category of source of financing PROPORTIONATELY
  • A firm’s weighted average cost of capital is a composite of the individual costs of financing weighted by the percentage of financing provided by each source.

How To Compute A Company’s Weighted Average Cost of Capital (WACC)

We can compute a company’s weighted average cost of capital(WACC) by:

  • First calculate the individual cost of financing like cost of debt, preferred stock and common stock
  • Secondly determine the percentage(weight) of debt, preferred stock and common stock to be used in the financing
  • Lastly, to calculate the firm’s WACC by multiplying the individual cost of financing with the percentage of financing.

Append below is a simple illustration on the computation of a company’s weighted average cost of capital (WACC):

Illustration:

Company ABC Ltd has the following sources of capital and has also determine its individual cost of capital:

Sources of Capital/Financing

$

Cost of Capital

Bonds

300,000

10%

Preferred stock

100,000

13%

Common stock

600,000

16%

1,000,000

The Management intends to invest in a $500,000 investment project with an expected rate of return of 12.5%.

Should the firm make the investment?

Suggested Solution:

Step 1: Determine the individual cost of financing

In this case, it has been given.

Step 2: Determine the weightage(%)

Sources of Capital/Financing

$

Capital Structure (%)

Bonds

300,000

30%

Preferred stock

100,000

10%

Common stock

600,000

60%

1,000,000

100%

Step 3: Compute the company’s WACC by multiplying the individual cst of financing with the weightage/% of financing:

Sources of Capital/Financing

Capital Structure (%)

Cost of Capital

WEIGHTED COST%

(A)

(B)

(A) X (B)

Bonds

30%

8%

2.4%

Preferred stock

10%

14%

1.4%

Common stock

60%

18%

10.8%

100%

14.6%

Final Step:

Compare the firm’s weighted average cost of capital (WACC) with the proposed rate of return from the capital investment:

Firm’s WACC = 14.6% Versus Rate of Return from Investment=12.5%

Reject the investment proposal as the firm’s WACC is higher than the project’s rate of return otherwise shareholders wealth will be eroded.

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