Calculating the WACC
Marginal Cost of Capital
If a company gets a specific loan or equity to finance a specific project then this loan/equity cost is the MARGINAL cost of capital.
Average Cost of Capital
If a company is continuously raising funds for many projects then the combined cost of all of these is the AVERAGE cost of capital.
Always use the AVERAGE cost of capital in exam questions, unless stated that the finance is specific
Calculating the WACC
Consider a company funded as follows:
Type | Amount | Cost of Capital |
Equity | 80% | 10% |
Debt | 20% | 8% |
What is the weighted average cost of capital?
Equity 80% x 10% = 8%
Debt 20% x 8% = 1.6%
WACC 9.6%
What we have ignored here is how did we get to calculate how the â€˜amountâ€™ of equity and debt was calculated - using book or market values?
Use MV where possible
Illustration
Statement of Financial Position
Ordinary Shares | 2,000 |
Reserves | 3,000 |
Loan 10% | 1,000 |
Ordinary shares MV = 3.75; Loan note MV 80;
Equity cost of capital = 20%; Debt cost of capital = 7.5% (after tax)
Calculate WACC using:
1) Book Values
2) Market Values
Solution
Using Book Values:
Equity | |
Ordinary Shares | 2,000 |
Reserves | 3,000 |
5,000 | |
Debt | |
Loan | 1,000 |
6,000 |
Equity 5,000/6,000 x 20% = 16.67%
Debt 1,000/6,000 x 7.5% = 1.25%
WACC 17.92%
Solution
Using Market Values:
Equity | ||
Shares | 2,000 x 3.75 | 7,500 |
7,500 | ||
Debt | ||
Loan | 1,000 80/100 | 800 |
8,300 |
Equity 7,500/8,300 x 20% = 18.07%
Debt 800/8,300 x 7.5% = 0.72%
WACC 18.79%
SUMMARY
To Calculate WACC
Calculate weighting of each source of capital (as above)
Calculate each individual cost of capital
Multiply through and add up (as above)