The cost of capital is a fundamental element in a firm’s financial decision making. When deciding on the optimal capital structure, firms allocate a certain percentage of cost on debt and cost of equity to finance their assets and provide a return on investment (ROI) to their shareholders.
If a firm has only common stocks, then the cost of capital is the required return on equity (ROE). However, the required rates on return are different because the risk undertaken for different classes of assets is different. Therefore, the Weighted Average Cost of Capital (WACC) is the weighted average cost of debt and equity that reflects the average riskiness of all the firm’s assets. In other words, WACC measures the capital discount of a firm’s debt and equity and represents the rate that a firm is expected to finance its assets. Since different classes of assets may be more or less risky than the average, the WACC should be adjusted accordingly to reflect the riskiness of capital budgeting projects. Therefore, WACC is the minimum return that the firm must earn based on its existing capital structure to satisfy its shareholders for owning its assets and bearing the risk of ownership.
WACC is calculated taking into account a firm’s capital structure with its after-tax cost of debt and cost of equity. Equity may include both common and preferred stocks. Debt may include stocks options, pension liabilities, and government subsidies.
a) Cost of Debt
The cost of debt is the effective rate that a firm pays off its debt. Usually, in capital budgeting calculations the cost of debt is computed as an after tax cost, after interest expenses are deducted. This facilitates the comparison with the cost of equity. The cost of debt provides investors with an idea about the firm’s riskiness as riskier firms typically have higher cost of debt.
b) Cost of Equity
The cost of equity represents the return that investors expect for owning a particular asset and undertaking the risk of ownership. To better illustrate the cost of equity, we assume that an investor requires a rate of return of 10% for owning an investment in company X. The current price of the stock is $12 and the dividend to be paid is $0.50. In effect, the investor requires $1.2 on his $12 investment. This means that the stock will have to appreciate by $0.70 so that, combined with the $0.50 from the dividend, gives the investor the 10% cost of equity.
How the WACC is calculated
WACC = (E/V × Re) + (D/V × Rd) × (1 − Tc)
E = the firm’s equity,
D = the firm’s debt
V = the firm’s total value (debt + equity)
E/V = the percentage of financing that represents equity
D/V= the percentage of financing that represents debt
Re = cost of equity
Rd = cost of debt after tax
Tc = tax rate
To calculate the value of each component of the WACC we assume that the weight of financing is the market value of the component divided by the total value of all components. Market value is preferred over book value because book value is difficult to be determined and also may be fundamentally different than market value thus significantly altering final figures.
The market value of equity (E) is calculated by multiplying the price per share by the number of shares outstanding (including preferred stocks if issued).
The market value of debt (D) is typically fairly close to the firm’s book value, particularly for firms that are more or less stable in credit rating.
The cost of equity (Re) is calculated using the CAPM model (capital asset pricing model). CAPM takes into account risk-free rate, market return and the firm’s beta to calculate the cost of capital for the firm in relation to the rate of return on its assets.
The cost of debt (Rd) is calculated after interest rates are deducted.