FINANCIAL MANAGEMENT

WEEK-9
QUESTION:
How to calculate the weighted average cost of capital?
To calculate the weighted average cost of capital (WACC), we need
to follow these steps:
Determine the market value of the company's debt and equity.
Determine the cost of debt.
Determine the cost of equity.
Calculate the weighted average cost of capital.
The formula for WACC is:
WACC = (E/V x Re) + (D/V x Rd x (1 - Tc))
Where:
E = Market value of the firm's equity
D = Market value of the firm's debt
V=E+D
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate
Here's how to calculate WACC using the above formula:
Determine the market value of the company's debt and equity.
Market value of equity = Number of shares outstanding x Market
price per share
Market value of debt = Total debt outstanding
Determine the cost of debt.
Determine the interest rate for each debt component.
Multiply each interest rate by the proportion of debt it represents in
the company's capital structure.
Add the products together to get the weighted cost of debt.
Determine the cost of equity.
Determine the expected rate of return on equity using the Capital
Asset Pricing Model (CAPM) or other methods.
Use the expected rate of return on equity as the cost of equity.
Calculate the weighted average cost of capital.
Multiply the market value of equity by the cost of equity.
Multiply the market value of debt by the weighted cost of debt.
Add the two products together.
Divide the sum by the total market value of the company's debt and
equity.
Here's an example of how to calculate WACC:
Suppose a company has a market value of equity of Rs. 6,00,000 and
a market value of debt of Rs. 4,00,000. The cost of equity is 12%, and
the cost of debt is 10%. The corporate tax rate is 30%.
Determine the market value of the company's debt and equity.
Market value of equity = 6,000 shares x Rs. 100 per share = Rs.
6,00,000
Market value of debt = Rs. 4,00,000
Determine the cost of debt.
Proportion of debt = Rs. 4,00,000 / (Rs. 6,00,000 + Rs. 4,00,000) =
0.4
Weighted cost of debt = 0.4 x 10% x (1 - 30%) = 0.028 or 2.8%
Determine the cost of equity.
Cost of equity = 12%
Calculate the weighted average cost of capital.
WACC = (6,00,000 / (6,00,000 + 4,00,000)) x 12% + (4,00,000 /
(6,00,000 + 4,00,000)) x 2.8% = 9.6%
Therefore, the WACC for this company is 9.6%