AFMP4
Syllabus B3cd. The Cost of CapitalCost of Capital - Intro

Calculating the WACC 2 / 2

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 ‘amount’ 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

  1. Calculate weighting of each source of capital (as above)

  2. Calculate each individual cost of capital

  3. Multiply through and add up (as above)