The company can employ two sources of capital, Equity capital (owners funds) and Debt Capital (loans, debentures etc), to conduct the operation of the company.
Weighted Average Cost of Capital (“WACC”) is the ‘average of the cost’ of these sources of capital. We have put an emphasis on the word ‘COST’ of capital. Accordingly, WACC is the minimum return that a company must earn on its existing capital to satisfy the respective stakeholder like shareholders, creditors, lenders etc. Mathematically, it is weighted average of the costs of each of the different types of capital which can be shown as the following equation:
E = Market value of equity
D = Market value of debt
P = Market value of preferred stock
V = E + D + P
Ke = Cost of equity
Kd = Cost of debt
Kp = Cost of preferred stock
t = tax rate
From the equation you must have noticed that for calculating the firm’s Weighted Average Cost of Capital you need to know its cost of debt and cost of equity.
CALCULATION OF THE COST OF EQUITY
Cost of equity could be understood as the minimum return which the equity shareholders want from the company. Put differently, it is rate of return that could have been earned by putting the same money into a different investment with equal risk. The cost of equity is usually calculated using the capital asset pricing model (CAPM), which defines thecost of equity as follows:
Rf: risk-free rate
β: Beta of the stock
(Rm − Rf): Market risk premium
Rm: Expected market return
Let’s explain what the elements of this formula are:
Rf = Risk-Free Rate = Risk-free Rate is a rate that an investor expects from an absolutely risk-free investment like government bond or long term bond.
ß = Beta = Beta, or the beta coefficient, is a number that measures the relative volatility of a security’s returns compared to the volatility of the market’s returns. The value of beta ranges from +1 to -1. If the beta is more than one, it implies a stock price grows dramatically when the market is up, and falls dramatically when the market goes down. Less than one beta means the share is relatively unaffected by the swings in the overall market’s return.
For Example: Consider the stock of Company A which has a beta of 0.8. This points to the fact that, Company A as a whole has been relatively less volatile as compared to the market as a whole. Its share price moves less than the market movement. Suppose Nifty index moves by 1% (up or down), Company A’s price would move 0.80% (up or down). If Company A has a Beta of 1.2, it is theoretically 20% more volatile than the market.
Rm – Rf = Market risk Premium= The equity market risk premium (EMRP) is the difference between the Expected market return rate and risk free rate. In other words, it represents the returns that investors expect, over and above the risk-free rate, to compensate them for taking extra risk by investing in the particular investment.
CALCULATION OF COST OF DEBT & COST OF PREFERENCE SHARE CAPITAL
Cost of debt and cost of preference capital are fairly straightforward to calculate as compared to cost of equity. It is the rate of interest which the company pays on its debt and preference share capital. Remember – in case of debt, the company benefits from the tax deduction available on interest paid, therefore we must multiply the interest rate paid by the company on its debt by (1- tax rate) to get the correct cost of debt.
The Weighted Average Cost of Capital thus arrived should be the rate at which the free cash flow must be discounted to obtain intrinsic value or net present value of investment.
Company X has 2, 00,000 shares of equity stock and 1, 00,000 shares of preferred stock of face value of Rs. 10. The equity share is currently trading at Rs.25 per share and the preferred stock have a coupon rate of 8 %. The risk free rate is 7.5 %. Investor’s expected market return is 15 % and the company has a beta of 0.90. Total debt capital being utilized by the company is Rs. 40, 00,000 with an interest rate of 8 %. The Company is in the 30 % tax bracket (current income tax rate on companies in India).
Total Value of capital (V) = 40, 00,000 + 50, 00,000 + 10, 00,000
= Rs. 1 Cr.
Cost of equity = Rf + β × (Rm − Rf)
= 7.5 % + 0.9 × (15 %-7.5 %)
= 14.25 %
Cost of debt = Interest rate × (1 – Corporate tax rate)
= 8 % × (1 – 30 %)
= 5.6 %
Cost of preferred stock = 8 %
= (50,00,000/1,00,00,000 × 0.1425) + (40,00,000/1,00,00,000 × 0.56) + (10,00,000/1,00,00,000 × 0.08)
= 10.17 %
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About the Author
Rajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.Follow @SanaSecurities