You are on page 1of 54

Topic 2: Cost of Capital

1
The cost of capital concept

Firms normally raise capital from borrowings, preference shares


and ordinary shares
Investors expect a higher return for a higher level of risk (example
ordinary shares) and lower required return for lower levels of risks
(example secured debts).
Each source of finance will involve different costs. The cost of
capital is therefore expressed as a weighted average that reflects
the costs of permanent sources of financing.
Therefore, the cost of capital is the minimum rate of return on
the firms investments that will compensate the suppliers of
capital to the firm.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 2
The cost of capital concept
Some investment projects may be funded, for example, by a new
issue of equity and at first glance we might think that the cost of
capital for that investment is the investors required return on the
new share issue.
However, a company usually consists of a collection of projects
and the investors participating in a new share made to finance a
particular project participate in the profit generated by all existing
and future projects of the company, not just the project the new
issue will be used to fund.
This means that the cost of a particular source of finance for an
investment made by the company does not tell the entire cost of
capital story.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 3
The cost of capital concept
The company needs to be able to generate sufficient return to
meet the claims of all providers of finance and still have enough
to cover the required return of ordinary shareholders.
If the company can earn more than the minimum rate of return
on the firms investments that will compensate the suppliers of
capital to the firm, the share price should increase.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 4
The cost of capital concept
Determinants of the cost of capital

Each of the different sources of finance used by the company


contributes to its total cost of funds.
The requirement for regular interest payments and the legal
provisions that allow creditors to call for the winding up of a
business mean that those supplying debt capital face the least
risk.
Therefore, we can expect creditors to have a relatively low
required return.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 5
The cost of capital concept
Determinants of the cost of capital

Preference shareholders face lower risks than ordinary


shareholders. We expect that the required return on this source of
funds would be higher than debt, but lower than that for ordinary
shares.
As ordinary shareholders are the residual claimants, and therefore
have the riskiest cash flows from their investments, we expect
that theyll have the highest required rate of return.
The required rate of return for preference shareholders will fall in
between that of the creditors and the ordinary shareholders.
Hence, we can conclude that the risk for each source of capital
drives the investors required returns.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 6
The cost of capital concept
Determinants of the cost of capital

The cost of capital is a composite measure that includes the cost


of each component (or source) of finance.
For example, assume a firm is financed using 50% debt and
50% equity. Assuming the cost of debt is 8% and the cost of
shares is 14%, the cost of capital would be 11% (0.5*8 +
0.5*14).
If the proposed project returns the cost of capital, the firms value
will remain unchanged. If the proposed project returns more than
the cost of capital, the value of the firm should increase.
Alternatively, if the proposed project returns less than the cost of
capital, the value of the firm would decrease.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 7
The cost of capital concept
Taxation regimes and the cost of capital

Resident shareholders live (and pay tax) in the same


country as the company paying the dividends.
Foreign shareholders live (and pay tax) in a different
country from that of the company paying the
dividends.
Franked Dividend: a dividend carrying and attached
franking or tax credit.
Fully Franked Dividend: a dividend that carries a tax
credit equal to the full percentage of company tax paid
on the underlying profit.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 8
The cost of capital concept
Taxation regimes and the cost of capital

Tax paid by a fully integrated company is passed on to


shareholders and profit distributed as dividends is
taxed only at the shareholders personal tax rate.
In this case, none of the imputation credits distributed
by the company are lost and corporate taxes are not
relevant in the determination of the cost of capital.
For fully integrated companies, the component costs
should be calculated on a before-tax basis.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 9
The cost of capital concept
Taxation regimes and the cost of capital

Companies that do not pay dividends are not


integrated into the dividend imputation tax system, as
any available franking credits are not passed on to
shareholders.
Foreign shareholders may gain no benefit from
receiving fully franked dividends.
For both companies that pay no dividends and foreign
shareholders, as well as business structured as sole
traders and partnerships, the after-tax cost of capital
is relevant.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 10
Estimating the component costs
Finding the margin cost of funds
Issues costs are the costs associated with bringing an
issue of securities to the market. Also known as
floatation costs for equity issues.
These costs include any underwriting fees and costs for
preparing a prospectus, in addition to costs associated
with the advertising and promotion of the issue.
It may be necessary for the firm to issue new equity
securities at an offer price lower than the current
market price to ensure sufficient funds are raised from
the issue. This discount is also considered a cost.
Issue costs are often stated as a percentage of the issue
price.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 11
The cost of capital concept
Determinants of the cost of capital

The net proceeds are the amount of cash received


from investors minus any costs associated with the
issue.
The marginal cost of a particular source of capital is
the cost associated with raising the next dollar from
that source.
The historic cost of funds raised is irrelevant when
comparing how much a new project would have to
earn to satisfy the suppliers of capital.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 12
Estimating the component costs
Finding the margin cost of funds
Equation 7.1 shows the relationship between net proceeds and
issue costs.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 13
Estimating the component costs
Calculating net proceeds of an issue
Keating Ltd is planning the issue of 1 million ordinary shares. The
shares will be offered to the market at $5 each. The investment
bank handling the issue has agreed to bear all the costs of the
issue for a fee of 4.6% of total funds raised. What net proceeds per
share can Keating expect and what would be the total net proceeds
from this issue?

NP = 5(1-0.046)
NP = $4.77

Total proceeds are therefore $4 770 000 (1 000000 x $4.77)

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 14
Estimating the component costs
Cost of debt

The cost of debt is the level of return that must be


generated in order to meet the required return of debt-
holders.
To estimate the cost of debt, one needs to find the required
return of debt holders.
The cost of previous issues is not relevant when we use the
cost of capital as a yardstick for assessing new projects.
Therefore, we measure the marginal cost of debt or the cost
associated with a new issue.
For ease of computation, we use zero coupon bonds
initially to calculate the cost of debt.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 15
Estimating the component costs
Cost of debt

Substituting the net proceeds for the intrinsic value in the


zero coupon valuation equation gives:

Solving equation 7.2 for rb will give us the before tax cost of
debt, denoted kz,bt.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 16
Estimating the component costs
Cost of debt

Clearly, to find the required return or cost of debt, we


need to find the discount rate that makes the PV of the
future cash flows equal to the net proceeds of the
bond. This discount rate is also called the internal
rate of return (IRR).
Interpolation is the process of approximating an
unknown return using trial and error.
The interpolation method is easiest to implement
using the IRR function embedded within a financial
calculator or a spreadsheet package such as Excel.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 17
Estimating the component costs
Cost of debt

The interpolation process begins with a guess at the


discount rate that will make the present value of the future
cash flows equal to the net proceeds of the bond. The same
process continues until you get one discount rate that gives
the nearest calculated price just above the net proceeds and
the next discount rate above that one gives a calculated price
just below the net proceeds.
The next step is to estimate where between our two discount
rates the cost of debt lies.
The whole process is demonstrated in the following
example:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 18
Estimating the component costs

Before- tax cost of zero coupon bonds


A zero coupon bond has a face value of $100,000 and 3 years to
maturity. Interest accrues on the bond annually. The net proceeds
of the bond are $90,000. What is the cost to the company of this
source of finance?

= 100 000/(1+kz,bt)3

Try 5% as a first pass at the cost of debt


= 100000/(1+0.05)3
= $86 385.63
(note: there is an inverse relationship between the discount rate and
the value of security. The higher the discount rate the lower the value
of security and vice versa.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 19
Estimating the component costs

Before- tax cost of zero coupon bonds


So we choose a lower discount rate. Try 4%.
NP= 100000/(1+0.04)3
= $88 896.79
So we choose a lower discount rate. Try 3%.
NP= 100000/(1+0.03)3
= $91 516.43

The calculated price using 3% discount rate is now too high


and as the next whole percentage was too low, we can tell that
the cost of debt is between 3% and 4%.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 20
Estimating the component costs

Before- tax cost of zero coupon bonds


So we take the interpolation between 3% and 4% as:
Difference of lower discount rate value and net
proceeds 91 516.43 90 000 = 1516.43
Difference of lower and higher discount rate value
91 516.43 88 896.79 = 2619.64
Take ratio of difference 1516.43/2619.64 = 0.5789
Lower rate ratio 3% +0.5789 = 3.58%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 21
Estimating the component costs
Cost of debt

Without a spreadsheet or financial calculator, a less


tedious way to approximate the cost of debt is to use
equation 7.3:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 22
Estimating the component costs
Before- tax cost of zero coupon bonds
Using the previous example: A zero coupon bond has a face value
of $100,000 and 3 years to maturity. Interest accrues on the bond
annually. The net proceeds of the bond are $90,000. What is the
cost to the company of this source of finance?

= 0+(100 000 90 000)/3


(100 000+90 000)/2
= 3333.33/95 000
= 0.35088 or 3.51%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 23
Estimating the component costs
Before- tax cost of zero coupon bonds

The approximate cost of the zero coupon bond is 3.51%.


This is a little different from the 3.58% we estimated
using the trial and error method. The difference is
attributable to the methods we used to approximate.
This method is less accurate than the previous method.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 24
Estimating the component costs
Before tax cost of coupon bonds
Coupon bonds have more cash flows than zero coupon bonds,
further complicating the estimation of the cost of debt. Thus the
following equation (7.4) is used:

Ct = coupon payment in period t

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 25
Estimating the component costs
Before tax cost of coupon bonds
Again, to find the required return or cost of debt, we
need to find the discount rate that makes the PV of the
future cash flows equal to the net proceeds of the
bond. This discount rate is also called the internal
rate of return (IRR).
The most efficient way to do this is by using the IRR
function in a spreadsheet or a financial calculator
Without access to a computer or a financial calculator,
the cost of debt on coupon bonds is approximated
using the trial and error (interpolation) method as
shown in the following example:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 26
Estimating the component costs
Before tax cost of coupon bonds
A bond has a face value of $100,000 and three years to
maturity. The coupon rate is 5% and coupon are paid
annually. The next coupon is due in 12 months time and the
issue will generate net proceeds of $90,000. what is the cost
to the company of this source of finance?

Try 9% as a first pass at the cost of debt


5000/(1.09)1 +5000/(1.09)2 +5000+100 000/(1.09)3
= $89 876.64
Try 8% as a first pass at the cost of debt
5000/(1.08)1 +5000/(1.08)2 +5000+100 000/(1.08)3
= $92 269.50

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 27
Estimating the component costs
Before tax cost of coupon bonds
We can tell from the calculation that a cost of 9% is too high and the
cost of 8% is too low. So we interpolate between these two rates to
get a better estimate of the cost of debt as shown:

So we take the interpolation between 8% and 9% as:


Difference of lower discount rate value and net proceeds
92 269.50 90 000 = 2269.50
Difference of lower and higher discount rate value
92 269.50 89 876.64 = 2392.86
Take ratio of difference 2269.50/2392.86 = 0.9484
Lower rate ratio 8% +0.9484= 8.95%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 28
Estimating the component costs
Before tax cost of coupon bonds
The previous use of interpolation method was fairly simple
because there were cash flows for only three periods, however this
becomes difficult with longer terms. As such the following formula
(Equation 7.3) could be applied

A bond has a face value of $100,000 and three years to maturity.


The coupon rate is 5% and coupon are paid annually. The next
coupon is due in 12 months time and the issue will generate net
proceeds of $90,000. what is the cost to the company of this source
of finance?
5000 + (100 000 90 000)/3
(100 000 +90 000)/2
= 0.087719 or 8.77%
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 29
Estimating the component costs
Cost of debt

The cost of debt calculations presented so far have been on a


before-tax basis.
When imputation credits are not available, maximising owners
wealth is achieved by maximising the after-tax return to owners.
We convert the before-tax cost of debt to an after tax cost of debt
using the following equation 7.5:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 30
Estimating the component costs
Cost of preference shares

The cost of preference shares is the level of return that


must be generated in order to meet the required return of
preference shareholders.
Substituting the net proceeds for the intrinsic value in the
preference share valuation equation and rearranging gives
equation 7.6 which is the cost of preference shares:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 31
Cost of Preference Shares
After-tax cost of preference shares
Legolas Ltd is planning the issue of preference shares at
an offer price of $100 per share. Dividend payments of
$5.35 will be made annually. Floatation costs are
estimated at 3.5% of offer price. What is the after-tax
cost of preference shares for Legolas?

where

= 5.35/(100(1-0.035)
=5.35/96.50
= 0.05544 or 5.54%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 32
Estimating the component costs
Cost of preference shares

The before tax cost of preference shares:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 33
Continued
Before-tax cost of preference shares
Given a corporate tax rate of 30% and the information
about the Legolas Ltd preference shares issue in
previous example, calculate the before-tax cost of
preference shares.

= 5.35/(1-0.30)
96.50
=7.64/96.50
= 0.0792 or 7.92%
The before-tax value of Legolass dividend consists of the cash
payment of $5.35 plus imputation credits of $2.29, giving a before tax
value of $7.64. the before tax cost of preference shares is 7.92%.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 34
Estimating the component costs
Cost of ordinary equity
The cost of ordinary equity is the level of return that must
be generated in order to meet the required return of the
ordinary shareholders.
The ultimate purpose of company earnings is to be paid as
dividends or to be reinvested in the company on the
shareholders behalf.
Retained earnings represent the accumulated profit of the
company that has not been paid out to shareholders as
dividends.
Retained earnings are not a free source of funds for new
projects.
Retained earnings belong to the ordinary shareholders and
the ordinary shareholders expect to get their required return
on this source of funds.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 35
Estimating the component costs
Cost of ordinary equity
After tax Cost of retained earnings
The cost of retained earnings is the required return of ordinary
shareholders on shares that have already been issued.
Assuming that the constant growth assumption is applicable to
the company in question, we can rearrange the constant growth
model to obtain the cost of retained earnings As in equation 7.8:

where: Dt = D0 (1 + g)t

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 36
Cost of Ordinary equity cost of retained earnings
After-tax cost of retained earnings
The ordinary shares of Legolas Ltd are currently
trading at $4.72. A dividend of 50c was recently paid and
the next dividend is due a year from now. The
estimated growth rate is 4% per annum. What is the
after-tax cost of retained earnings for Legolas?

;where: Dt = D0 (1 + g)t

= 0.50(1+0.04)/4.72 +0.04
= 0.52/4.72 + 0.04
= 0.150169 or 15.02%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 37
Estimating the component costs
Cost of ordinary equity
Before tax Cost of retained earnings
The before-tax cost of retained earnings for a company that
pays a fully franked dividend uses the grossed up dividend
amount. Equation 7.9 gives this cost:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 38
Continued
Before-tax cost of retained earnings
If the corporate tax rate is 30% and Legolas pays fully
franked dividends, what is the before-tax cost of
retained earnings?

= 0.50(1+0.04)/(1-0.30) + 0.04
4.72
= 0.52/0.7 + 0.04
4.72
= 0.1974 or 19.74%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 39
Estimating the component costs

Cost of ordinary equity


Cost of new share issues
The cost of ordinary shares is the required return of
shareholders on a new issue.
The main difference between estimating the cost of new
ordinary shares and retained earnings is the use of net
proceeds rather than current market price.
The formula for calculating the after tax cost of ordinary
shares is given by equation 7.10:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 40
Cost of new share issues

After-tax cost of new share issue

The ordinary shares of Legolas Ltd are currently


trading at $4.72. A new share issue would be made at an
offer price of $4.70. Issue costs are expected to be 3% of
the proceeds of the issue. The last dividend was 50c and
the next dividend is due a year from now. The
estimated growth rate is 4% per annum. What is
Legolas after-tax cost of an ordinary share issue?

= 0.50(1+0.04) + 0.04
4.70(1-0.03)
= 0.52/4.56 + 0.04
= 0.15404 or 15.4%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 41
Estimating the component costs
Cost of ordinary equity
Cost of new share issues
To obtain the before-tax cost of a new issue we gross up the
dividend to reflect the 100% franking credits. The equation
for the before-tax cost of a new issue is (7.11):

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 42
continued
Before-tax cost of new share issue

If Legolas pays fully franked dividends and the


corporate rate is 30%, what is the before-tax cost of a
new issue of ordinary shares?

= 0.50(1+0.04) /(1-0.30) + 0.04


4.56
= 0.1629+0.04
= 0.2029 or 20.30%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 43
Estimating the component costs
Cost of ordinary equity
Cost of new share issues
We can use the CAPM as an alternative to the dividend
discount model to calculate the cost of ordinary shares.
The after-tax cost of ordinary shares is given by equation
7.12:

Where : equity risk premium is

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 44
CAPM and the after-tax costs of ordinary shares

Arwyn Ltd has a beta of 1.6. the current risk-free


rate is 5.5% and the equity risk premium (ERP) is
5%. What is the after-tax cost for the ordinary
shares of Arwyn?

= 0.055+1.6(0.05)
= 0.135 or 13.5%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 45
Estimating the component costs
Cost of ordinary equity
Cost of new share issues
While the CAPM does not require forecasts of
dividends or assumptions about a dividend growth
rate, it does need a forecast of the equity risk premium,
E(RM)-Rf, a measure of the risk-free rate, Rf, and a
measure of systematic risk, , of the firm.
Another complication with applying the CAPM to
calculate the cost of ordinary shares is that the model
does not incorporate floatation costs.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 46
The weighted-average cost of capital

The weighted-average cost of capital (WACC) is the


sum of each component cost of capital weighted by
each component costs proportion of the firms capital
structure.
When we assess a project to determine its impact on
the value of the firm, we need to take a wider view
than determining if the project is expected to return
more than the component cost of finance that would
be used to fund the project.
Equation 7.13 shows how the weighted cost of capital is
derived from the component costs.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 47
The weighted-average cost of capital

It tells us to take each component cost (kx) and multiply it by the


proportion, Wx, that kx represents in the firms capital structure.

We need to have calculated the component costs and the


proportion that each component represents in the firms capital
structure in order to determine the WACC.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 48
The weighted-average cost of capital
Example
The financial manager of Exa-Life has identified the amount of
funds attributable to each component of the cost of capital and the
amount derived from each source of funds as follows:
Source of Funds Component Amount of
costs(kx) Financing
Term loans 0.067 2 000 000
Bonds 0.081 20 000 000
Preference Shares 0.085 10 000 000
Ordinary Shares 0.125 50 000 000

Therefore we have figures for kx to use in the equation, so the next


step is to determine the weights, Wx. To do this we total the amount
derived from each source of funds and divide the amount
attributable to each component by the total funding amount.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 49
The weighted-average cost of capital
Example contd
Source of Funds Amount of Proportion of total funding (Wx)
Financing
Term loans 2 000 000 2 000 000/82 000 000 = 0.0244
Bonds 20 000 000 20 000 000/82 000 000 = 0.244
Preference Shares 10 000 000 10 000 000/82 000 000 = 0.122
Ordinary Shares 50 000 000 50 000 000/82 000 000 = 0.61
82 000 000 1.00

So the WACC is:


Source of Funds Component Proportion(Wx) Weighted
costs(kx) cost(kx x Wx)
Term loans 0.067 0.0244 0.0016

Bonds 0.081 0.244 0.0198

Preference Shares 0.085 0.122 0.0104

Ordinary Shares 0.125 0.61 0.0763

WACC 0.108

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 50
The weighted-average cost of capital

The WACC for Exa-Life is 10.8%


As an alternative to the table, the WACC can be calculated
using the following equation directly as follows:

WACC = (0.067 x 0.0244)+ (0.081 x 0.244)+ (0.085x 0.122)+ (0.125 x 0.61)


= 0.0016+0.0198+0.0104+0.0763
= 10.8%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 51
The weighted-average cost of capital
Alternatives for weighting

The two main alternatives for weighting the component costs of


capital to obtain the WACC are book value weights and target
weights.
The book value weighting method bases the weights on the firms
current balance sheet. This results in a weighting scheme that
reflects how the firm has been financed in the past.
However, the book values shown in the balance sheet do not
reflect the current value of the firm.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 52
The weighted-average cost of capital
Alternatives for weighting

Book value is the accounting measure of an assets


worth.
Current market values are more relevant to decisions
that will impact on future market value.
A better weighting alternative is to use target weights
(based on market values) for each source of funding.
Target weights are based on managements future plans
for financing the companys operations.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 7, Australia: Wiley. 53
54