Weighted average cost of capital (WACC) is a calculation of company’s cost of capital when each category of capital is weighted depending on its proportion. The WACC is the useful rate for evaluating the expense of attracting future projects. The formula for calculation WACC will be the following:
Weighted Average Cost of Capital (WACC) = (KD * D) + (KE * E) + (KR * R)
Where:
- D = Proportion of debt capital in capital structure
- KD = Cost of debt in capital structure after tax
- E = Proportion of equity capital in capital structure
- KE = Cost of equity in capital structure
- R = Proportion of retained earnings in capital structure
- KR = Cost of proportion of retained earnings in capital structure
Step 1. Calculation cost of debt
Cost of debt is an interest a company has to pay for its borrowings. It ican be calculated as before- and after-tax and is expressed as a percentage rate. The cost of debt must be corrected by the amount of tax using the formula:
Kd after tax = Kd *(1-tax) =12.5 %* (1-0.6) =4%
Step 2. Calculation of cost of equity share using earnings-price ratio
The cost of equity is basically the amount of money the shareholders require for the investment in your company. It represents the compensation demanded by the market for being the owner of the asset and bearing the risks of ownership. The calculation of cost equity share is as follows:
Ke =EPS/MP
Where:
- E = Earnings per share
- MP= Market price per share
Using the information about the after-tax profit of Rs 6,750 and the number of equity share of 450, the earnings per share (EPS) is presented in the table below.
Profit after-tax, Rs. |
6,750 |
Divided by: Number of share |
450 |
Earnings per share (EPS), Rs. |
15 |
If the market price of the share is Rs. 120, the cost of equity share will be the following:
Ke =15/120 = 0.125 or 12.5%
Step 3. Calculation cost of retained earnings
The cost of retained earnings is the cost of company’s founds that are generated internally. If those costs are not retained internally, they will be going to the hands of investors in the form of dividens. The cost of retained earnings will be similar to the cost of equity share:
KR = Ke =12.5%
Step 4. Calculation of weighted average cost of capital
WACC is the rate the company isexpected to pay on average to all its security holders. It is controlled by external market and not the management itself. Using the formula above for WACC, the calculation is presented in the table below
Source of Funds | Amount, Rs. | Proportion | Cost | Weighted Cost (Proportion x Cost) |
Debt | 26,000 | 33% | 4.0% | 1.30% |
Equity Share | 45,000 | 56% | 12.5% | 7.03% |
Retaining Earnings | 9,000 | 11% | 12.5% | 1.41% |
Totals | 80,000 | 100% | WACC | 9.74% |
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