Weighted Cost of Capital

Cost of capital can be described as the opportunity cost of the entire capital invested in an enterprise that is, the cost of preceding the next available investment alternative by substituting with the current investment. The cost of capital can, therefore, be referred as the rate of return that the investors such as bondholders and enterprise owners will require in return as compensation for their injection of capital into an enterprise. Since the cost of capital is associated with investing can also be referred as marginal cost, that is, the cost of raising additional capital. Therefore in simple terms, an enterprise’s cost of capital is an enterprise’s cost of using money contributed by creditors and shareholders or owners. In most cases, the cost of capital is usually expressed in percentage terms, that is, the annual amount of money that an investor expects to raise expressed in percentage terms against the total amount of money invested in an enterprise (Pratt and Grabowski, 2008) Calculating weighted cost of capital.

The weighted cost of capital is computed in three steps. The first step is computing the cost of each capital that the company uses, that is debt and equity. The second step in calculating the WACC is determining the proportion that both equity and debt contribute to the company by using market values of total debt and equity which investors will expect to earn a return from. The last step will be weighing each capital, debt and equity by the proportion contributed by each kind of capital to the entire capital structure hence the weighted average cost of capital (WACC) (Energy Regulatory Office, 2006).The following formula combines the above explanation and therefore making it easier to determine an enterprise’s WACC .

Where

Ke=Cost of equity

Ve=Market value of equity

Vd=Market value of debt

Kd=Market value of debt

t= Tax rate (Energy Regulatory Office, 2006)

When a company has more than two sources of capital for instance, debt, owners’ equity and preference shares and each source has a separate cost, then the following formula is used.

Where

Ke=Cost of equity

Kd=Market value of debt

Ve=Market value of equity

Vd=Market value of debt

Vp=Market value of preference shares

t= Tax rate (Energy Regulatory Office, 2006)

Therefore, The Secure and Safe Waste Management Company’s current weighted cost of capital will be calculated as follows;

First we will breakdown various sources of capital and their costs as follows.

Market Value of Debt (Bonds)- $ 50 million

Cost of Debt-5.5% coupon

Market value of Owners’ Equity (Common Stock)-$25 million

Cost of Equity-12%

Market value of Preference Shares- $20 million

Tax rate- 30%

Using the formula, the company’s weighted cost of capital will be;

WACC=0.03%+0.01%+0.02%=0.06%

Current WACC will therefore be 0.06%

If the $45 million dollar bond issue with a 4.5% coupon is approved Secure and Safe Waste Management Company’s weighted cost of capital will be calculated as follows;

Its new debt capital will be;

$50 million+ $45million= $95million.

And its new cost of debt will be;

5.5%+4.5%=10%.

Therefore using the formula, , the company’s new weighted cost of capital will be;

12%*0.18+0.07*0.68+5.5%*0.14

0.02+0.05+0.01=0.08

Therefore the new WACC after approving the $45 million bond will be 0.08%

Tax shield advantage provided by Debt capital

According to studies, the use of debt capital is advantageous to an enterprise since the company will enjoy tax relief on interest payment which makes its cost of capital relatively cheaper. Therefore when a company is shielded from tax on interest payment, the cost of debt is consequently lowered and therefore outweighing the increasing cost of equity hence lowering the entity’s WACC (First Intuition, 2016). Therefore, Secure and Safe Waste Management Company will enjoy tax relief on interest payments and thus a lower WACC.

References

Energy Regulatory Office. (2006). Weighted Average Cost of Capital. Retrieved from Energy Regulatory Office website: http://www.ero-ks.org/Price%20and%20Tariffs/WACC_Assumptions_FINAL_eng.pdf

First Intuition. (2016). WACC. First intuition.

Pratt,, S. P., & Grabowski, R. J. (2008). Cost of Capital: Applications and Examples (3rd ed.).