Example 1
Example of Cost of Capital calculations using WACC
Aero Ltd had the following cost capital structure employed for financing its projects and
would like to calculate the cost of capital.
Amount After-tax
( Rs. ) Cost %
Equity share capital 8,00,000 16% 0.0225
Retained earnings 4,00,000 15% 0.03
Preference share capital 6,00,000 12% 0.025
Debentures 6,00,000 9% 0.053
Total 24,00,000
Calculation of Cost of capital of Aero Ltd
Source Amount (Rs. ) Weights After-tax Weighted
(Specific Cost (Cost Cost
(1) Capital/Total %/100)
cost) (4) = (2) *(3)
(3)
(2)
Equity share capital 8,00,000 0.34 0.16 0.053
Retained earnings 4,00,000 0.16 0.15 0.024
Preference share 6,00,000 0.25 0.12 0.03
capital
Debentures 6,00,000 0.25 0.09 0.023
Total 24,00,000 1.0 0.13
Weight Average Cost of Capital here is 13% (0.13*100). This implies that the overall
cost of capital employed by Aero Ltd is 13%. In other words, we can say that the
company is paying a premium of 13% to the lenders of capital as a return for their risk.
You can use the formula we discussed, and the result will be similar.
= (6,00,000 / 24,00,000) * 0.09 + (6,00,000 / 24,00,000) * 0.12 + ( 4,00,000 /
24,00,000 ) * 0.15 + ( 8,00,000 / 24,00,000) * 0.16 = 13%
Determining Cost of Capital is one of the key factors in deciding the investment. It helps
you in evaluating the different investment projects basis the cost, benefits and risks.
Another important factor to be considered here is capital budgeting and payback period.
Here, the payback period is nothing, but the time taken to recover the investment
amount. Read "What Is Capital Budgeting? Process, Calculation and Example’ to know
the process and calculations.
Example 2
Assume newly formed Gold Company needs to raise $1.5 million in
capital so it can buy an office and the necessary equipment to run its
business. The company raises the first $800,000 by selling stocks.
Shareholders demand a 5% return on their investment, so the cost of
equity is 5%.
Gold Company then sells 700 bonds for $1,000 each to raise the rest
of the $700,000 in capital. The individuals who purchase those bonds
expect a 10% return, so Gold's cost of debt is 10%.
Gold Company's total market value is calculated as ($800,000 equity +
$700,000 debt) = $1.5 million, and its corporate tax rate is 25%. The
weighted average cost of capital can be calculated using the formula
below:
WACC = ($800,000 / $1,500,000) x .05) + ($700,000 / $1,500,000)
x .10) * (1 - 0.25) = 0.038 = 3.8%
Gold company's weighted average cost of capital is 3.8%.
Example 3
A corporation is considering a capital project for the coming year.
The project has an internal rate of return of 14 percent. If the firm has
the following target capital structure and costs, what should their
decision be and why?
Answer:
ka = (0.40)(10%) + (0.10)(15%) + (0.50)(20%) = 15.5%
They should reject this project, because the weighted average cost of capital is 15.5
percent and the internal rate of return is 14 percent.
Example 4
Promo Pak has compiled the following financial data:
(a) Calculate the weighted average cost of capital using book value weights.
(b) Calculate the weighted average cost of capital using market value weights.
Answer:
(a)
ka = (0.5)(5) + (0.05)(14) + (0.45)(20) = 2.5 + 0.7 + 9 = 12.2%
(b)
ka = (0.34)(5) + (0.06)(14) + (0.60)(20) = 1.7 + 0.84 + 12 = 14.5%
Example 5
A firm has determined its cost of each source of capital and optimal capital structure,
which is composed of the following sources and target market value proportions:
If the firm were to shift toward a more leveraged capital structure (i.e., a greater
percentage of debt in the capital structure), the weighted average cost of capital would
A) increase.
B) remain unchanged.
C) decrease.
D) not be able to be determined.