A NOTE ON THE WEIGHTED AVERAGE COST OF CAPITAL

COMPUTATION OF COST OF CAPITAL

Identify the Firm’s Capital Market Structure (i.e., Source of Finance)

Computation of Market Value of Computation of the Composite Cost

each Source of Capital of Capital

Computation of Weighted
Average Cost of Finance

The current weighted average cost of capital (WACC) of a company reflects the required returns of
existing providers of finance, such as the cost of equity of shareholders and the cost of debt of
providers of debt finance, for example, banks and loan note holders.
WACC =we k e +w p k p+ wd k d + wb k b

where
w e , w p , wd ,∧wb : are the weights of the ordinary shares, preference shares, debentures, and bonds that
make up the capital market structure of the firm.
k e , k p , k d ,∧k b : are the costs of the ordinary shares, preference shares, debentures, and bonds that
make up the capital market structure of the firm.

2 Steps:
1. Calculate the market values of each source of capital and then the weights.
2. Calculate the composite costs of each source of capital.

EXAMPLE
BVG Bank is South Africa’s fastest growing bank. They are focused on the middle to lower income
groups. They strive to simplify banking and have developed an all-inclusive banking solution. What has
made them prosper is that they ensure that they do whatever they can to make banking accessible to
everyone. They have also reduced unnecessary paperwork which has resulted in a reduction of admin
fees which allows them to pass on the cost-saving to the customer. BVG Bank recently unveiled their
500th branch in Morning Glen. They then unveiled their plans to double the number of branches they
have by 2028. This project will require significant capital over the period. After a capital budget was
performed, the Financial Director wanted to make sure that the internal rate of return (IRR) of the
project was indeed greater than the cost of capital. He has asked you to calculate the cost of capital.
The following Statement of Financial Position and notes were made available to you:

BVG BANK LIMITED

STATEMENT OF FINANCIAL POSITION AS AT 28 FEBRUARY 2022
Notes 2022
R
Fixed Assets 916 890
Cash and Cash Equivalents 5 683 836
Loans and Advances to clients 19 927 932
Other current assets 2 135 376
Total Assets 28 664 034

Equity and Liabilities

Ordinary share capital and premium 1 3 837 354
Preference shares and premium 2 517 938
Retained earnings 2 545 734
6 901 026
Liabilities
Bonds 3 2 911 200
Debentures 4 4 085 000
Customer Deposits 13 688 566
Other Current Liabilities 1 078 242
21 763 008
Total Equity and Liabilities 28 664 034

Note 1
 The share premium equated to R3 801 354. The shares have a par value of R1 per share.
 The shares of BVG were trading at R168 at the close of business on 28 February 2022.
Note 2
11% preference shares were issued at a par value of R10. The preference shares are cumulative, non-
redeemable preference shares. BVG Bank has 1 000 000 authorised preference shares and 400 000
issued preference shares. Preference shares were trading at R9 per share at the close of business on
28 February 2022.
Note 3
The bonds were issued with the following terms:
 9.6% bonds were issued at par with a semi-annual; coupon payment.
 The bonds will be redeemed in 5 years’ time at a premium of 5% of the nominal value. Management
could not determine the market related yield of the bonds, so they decided to benchmark the rate to
the risk-free rate to be used. The Financial Director was happy to use a before tax premium of 2.5% on
the risk-free rate to represent the market related interest on the bonds.

Note 4
8% Debentures were issued to selected lenders on 28 February 2022. This was because special
repayment terms were negotiated with the particular lenders as not everyone was happy with the
repayment terms proposed.
The repayment terms have been agreed on as follows:
 The debenture will be settled in 5 years’ time.
 The par value of R4 300 000 will be paid back at a premium of 40% at the end of the 5-year term.
The debentures were issued at a discount of 5% of the par value.

Additional information:
 The company tax rate is 28%
 The Financial Director searched the Reserve Bank website and found the following information for
retail government bonds:
Name Coupon Market Yield Maturity
R158 5.93% 6.71% 15 September 2025
R203 7.65% 8.42% 15 September 2028

When the head of the Monetary Policy Committee (MPC) and Governor of the Reserve Bank
announced that interest rates were going to remain stable at the last MPC meeting, the returns of the
market increased by 2% and the returns of BVG Limited increased by only 1.7%.
The market risk premium as per recent study was 6.2%.

REQUIRED:
Calculate the weighted average cost of capital of BVG Bank as at 1 March 2022 by using market
values. Show all calculations.
SOLUTION:
Ordinary shares:
Share ccapital∧share premium
Total number of shares=
par value
R 3 837 354
¿
R1
¿ 3 837 354

Of the total number of 3 837 354 shares, 3 801 354 shares are reserve shares. That means the
number of shares available on the market is 36 000 (= 3 837 354 - 3 801 354).
Market value of the ordinary shares, Ve = Number of common stock x Market price
= 36 000 x R168 = R6 048 000

Change ∈Return of BVG Bank 1.7 %

β= = =0.85
Change ∈returns of market 2%

The risk-free rate of the capital-asset pricing model and modern portfolio theory is hypothetical but the
suggested real-world proxy is the yield on short-term government bills. Thus, the market yield on the
R158 was selected as the appropriate risk-free rate, r f =6.71 %
Using CAPM;
k e=r f + β ( r M −r f )=r f + β × Market Risk Premium
¿ 6.71 %+ 0.85× 6.2 %=11.98%

Preference shares:
Market value of the preference shares, Vp = Number of issued preference shares x Market price
= 400 000 x R9 = R3 600 000
Cost of preference shares, ke = D/Po = (11%xR10)/9% = 12.22%

Bonds:
Nominal price of bond = R2 911 200
Coupon rate = 9.6%
Annual coupon payment = Nominal bond price x Coupon rate = R2 911 200x9.6% = R279 475.20
Semi-annual coupon payment = Annual coupon payment/2 = R279 475.20/2 = R139 737.60
Periods , N =5 ×2=10

(Note: The market yield on the R153 has been selected as the appropriate risk-free rate)
-

Annual yield to maturity = risk-free rate + premium benchmark rate = 6.71% + 2.5% = 9.21%
9.21 %
ytm /2= ≈ 4.61
2

10
Semiannual coupon 1.05 × Nominal value
V B =∑ +
( ) ( )
t 10
t=1 ytm ytm
1+ 1+
2 2

10
R139 737.60 1.05 × R 2 911 200
¿∑ +
t=1 ( 1+4.61 % )t (1+ 4.61 % )10

¿ R 139737.60 × PVIFA ( 10 ; 5.61 ) + R 3 056760 × PVIF (10 ; 4.61)

Using MS Excel, the annuity and discount factors are 7.87 and 0.6372, respectively.

¿ R 139737.60 ×7.87 + R 3 056760 × 0.6372

¿ R 1099 734.91+ R 1 947 767.47

¿ R 3 047 502.38

After Tax:
Cost of bond , k b= ytm ( 1−Tax Rate )=4.61 % × ( 1−28 % )=6.63 % ≈ 6.62 %

Debentures:
To calculate the issuance of the 8% Debentures, we need to consider the following information:
  Par value: R4 300 000
 Premium: 40%
 Discount: 5%
 Debentures on Statement of Financial Position (SFP): R4 085 000

Par value of debentures before discount = R4 085 000/95% = R4 300 000

Fixed Interest per debenture = 8% x R4 300 000 = R344 000

Redemption payout at year 5 = 1.4 x R4 300 000 = R6 020 000

Number of debentures = R4 300 000/ R4 300 = 1000

Before Tax:
1
Interest + ( Redeemable Value−Net Proceeds )
n
Yield ¿ maturity , k d = ×100
1
( Redeemable Value + Net Proceeds )
2

1
R 344 000+ ( R 6 020 000−R 4 085 000 )
5
¿ ×100
1
( R 6 020 000+ R 4 085 000 )
2

R 344 000+ R 387 000

¿ ×100
R 5 052500

¿ 14.47 %

5
Annual Interest Nominal value
V B =∑ +
t=1 ( 1+ ytm )t ( 1+ ytm )5

5
R 344 000 R 6 020 000
¿∑ +
t=1 ( 1+ 14.47 % ) ( 1+14.47 % )5
t

¿ R 344 000 × PVIFA ( 5 ;14.47 ) + R 6 020 000× PVIF(5 ; 1447)

Using MS Excel, the annuity and discount factors are 3.3947 and 0.5088, respectively.

¿ R 344 000 ×3.3947+ R 6 020 000 × 0.5088

¿ R 1167 776.80+ R 3 062 976

¿ R 4 230 752.80

After Tax:
Cost of debentures , k d =14.47 % × (1−Tax Rate )

¿ 14.47 % × ( 1−28 % )

¿ 10.42 %

Security Market values, R Weights Cost Weighted cost

Ordinary shares 6 048 000 0.3573 11.98% 4.280454%
Preference shares 3 600 000 0.2127 12.22% 2.599194%
Bonds 3 047 502.38 0.1800 6..62% 0.5976%
Debentures 4 230 752.80 0.2500 10.42% 2.605%
Total 16 925 255.18 1.0000 10.08%

WACC = 10.08%