Jan
6
2010
TuesdayTips
Author: frederickpoole1953WACC
Calculating WACC – Scenario I
You have been presented with all the variables, and need only to calculate the WACC. This is by far the easiest way to calculate WACC. (Note: The below example doesn't have preferred stocks)
Provided Variables:
Weight of Debt: 60%
Cost of Debt: 10%
Weight of Equity (Common Stock): 40%
Cost of Equity (Common Stock): 18%
Tax Rate: 35%
WACC = Weight of Debt * Cost of Debt (1-Tax Rate) + Weight of Equity * Cost of Equity
= (.6) * (.1)*(1-.35) + (.4) * (.18)
= .111 or 11.1%
So, the Weighted Average Cost of Capital (WACC) in Scenario I was 11.1%
Calculating WACC – Scenario II
Here, you have been provided with Debt-Equity Ratio, Cost of Debt, Cost of Equity, and the Tax Rate. In order to Calculate WACC, you need to find out Weight of Debt and Weight of Equity.
Weight of Debt and Weight of Equity can be found from Debt – Equity Ratio through the formulas
Weight of Debt = (Debt-Equity Ratio) / (1 + Debt-Equity Ratio)
Weight of Equity = 1 / (1 + Debt-Equity Ratio)
Solving the problem:
Listed Variables
Debt-Equity Ratio: .6
Cost of Debt: 10%
Cost of Equity 18%
Tax Rate: 35%
WACC = ?
Step 1: Calculate Weight of Debt and Weight of Equity
Weight of Debt = Debt-Equity Ratio / (1 + Debt-Equity Ratio) = .6/ (1+.6)
Weight of Debt = .375 or 37.5%
Weight of Equity = 1 / (1 + Debt-Equity Ratio) = 1 / (1 + .6)
Weight of Equity =.625 or 62.5%
Step 2: Calculate WACC
WACC = Weight of Debt * Cost of Debt (1-Tax Rate) + Weight of Equity * Cost of Equity
WACC = (.375) * .1(1-.35) + (.625) * (.18)
WACC = .136875
WACC = 13.69%
In the above example we got Weighted Average Cost of Capital as 13.69%
Calculating WACC – Scenario III Preferred Stocks
In Scenario 3, you have been presented with all variables, but this time around, the WACC calculation includes Preferred Stocks.
Listed Variables:
Tax Rate : 40%
Cost of Common Stock: 13.9%
Cost of Preferred Stocks: 5.8%
Cost of Debt: 6.40%
Weight of Common Stock: 63.93%
Weight of Preferred Stock: 6.61%
Weight of Debt: 29.46%
WACC = Weight of Debt * Cost of Debt (1-Tax Rate) + Weight of Common Stocks * Cost of Equity + Weight of Preferred Stocks * Cost of Preferred Stocks
WACC = 29.46% * 6.40% (1-40%) + 63.93% * 13.9% + 6.61% * 5.8%
WACC = 10.40%
All the 3 listed above examples are very basic calculations for WACC. I will list more complex examples of WACC Calculations in the near future.
Also, in the above examples we assumed that we knew how to calculate or were given the Cost of Equity, Cost of Debt, Cost of Preferred Stocks, and as such. In later sections, I will also explain how to find Cost of Equity, Cost of debt, Cost of Preferred Stocks, Weight of Common Stocks, Weight of Bonds, and Weight of Debt.
Praveen
Shetty, 32, who lives in Mumbai, earns Rs 14 lakh a year, while his wife’s
annual income amounts to Rs 7 lakh. They have purchased two houses and have
availed of home loans for the same. The total EMI outgo stands at Rs 40,000.
Other expenses amount to Rs 17,000 per month. Investments are primarily in
insurance policies, which entail a total annual premium of Rs 82,000. Mr
Shetty’s goals include repaying the two home loans within five years and
saving for the education of his one-year-old son.
RECOMMENDATION
With
the increase in options for the type of education systems available today, the
cost of children’s education is escalating, especially in metros. One may
have to plan for higher costs right from early education years unlike only for
higher education from the 18th year, which has been an accepted practice until
now. We feel a general inflation rate of 6% may sometimes fall short, keeping in
mind the spiralling education costs, extra curricular activities, creche
facilities, etc. The Shettys’ goal of building a corpus of at least Rs
25,00,000 for their son in his 18th year, would cost around Rs 67 lakh then,
considering a 6% inflation rate.
We suggest creation of an emergency
fund for any unseen events which may disturb cash inflows in the short term. In
such a case, to provide for fixed cash outflows for a period of say, six months,
they need to set aside Rs 3,50,000. With the current savings bank balance being
Rs 1,00,000, the remaining amount could be built up over a period of a year by
putting aside Rs 22,500 per month in a higher yielding liquid debt fund. The
Shettys also need to look at health and life insurance plans to ensure risk
coverage for dependents.
Accidents, illnesses, etc, besides causing
disturbances in inflows may cause a huge dent in one’s outflows due to
medication and hospital expenses. It’s highly recommended to take a family
health insurance policy which may cost the family approximately Rs 10,000 a
year. Along with this, a term cover of up to 15 years for approximately Rs 1.5
crore is advisable. Mr Shetty could top up his existing money back policy up to
Rs 1.5 crore, or by taking a pure term policy for the sum assured, which should
cost approximately Rs 25,000 per year.
After providing for the
recommended insurance premiums on policies, they will have a surplus of Rs
58,000 per month. The Shettys need to build up a portfolio, keeping in mind an
asset allocation which would help them realise their goals without an excessive
strain on their risk tolerance. It is advisable to start a PPF investment to
begin with (which gives best tax effective, risk-free returns at 8% currently)
for the debt allocation. One could also look at floater-MIP combinations to
create a suitable debt portfolio.
For equity allocation, considering
their young age and no investments, we recommend the balance (Rs 38,000 p.m.) to
be invested in growth and value-oriented mutual funds in a systematic investment
format. Out of this, Rs 16,000 pm could be allocated towards the child’s
corpus for the next 15 years. At 10% pa, this would yield a return of Rs 67 lakh
after 15 years. He could look at transferring this corpus to debt investments
for the next two years, till required for his child’s 18th year.
Note: The plan would need to be evaluated for all incremental
salaries and at the time of repayment of home loan, money back from insurance
policies and any other material changes in cash inflows and
outflows.
Prerana Salaskar-Apte, a certified financial planner, is a
partner with financial planning firm, The Tipping Point
The cost of capital is a key factor in choosing the mixture of debt and equity used to finance a firm. Most firms employ several capital components such as common or preferred stocks, along with debt in order to finance their investments and provide a return on their investments to their shareholders.
If a firm has only common stocks, then the cost of capital is the required return on equity. However, as most firms employ different types of capital components, the required rates on return are different due to differences in risk. Therefore, the cost of capital should be calculated as a weighted average of the various components' costs in order to reflect the average riskiness of all the firm's assets from raising new debt in the planning period. This weighted average is the Weighted Average Cost of Capital (WACC).
Analyzing the WACC components
Weighted Average Cost of Capital (WACC) is calculated using the firm's target capital structure together with its after-tax cost of debt, cost of preferred stock, and cost of common equity.
Weighted Average Cost of Capital (WACC) can be calculated as follows:
WACC = WdRd(1-T) + WpsRps + WceRs
where:
• Wd: the weight of debt = the target proportion of debt
• Wps: the weight of preferred stocks = the target proportion of preferred stocks
• Wce: the weight of equity = the target proportion of equity
The percentages (weights) of each capital component are based on the firm's optimal capital structure.
• Rd(1-T): after-tax cost of debt = it is the rate of return that debt holders require and it is calculated after tax because interest is deductible.
• Rps: cost of preferred stock = if the firm issues preferred stocks, then Rps is included in the WACC calculations, but without tax adjustments. Firm bears their full cost.
• Rs: cost of common equity = it is the rate of return on the equity raised either through the issue of new shares or through retaining earnings. Normally, the cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which takes into consideration that risk free rate (RRF), the expected market risk premium (RMP) and the beta (b) coefficient of the firm's stock.
Example
We need to calculate the WACC of firm X assuming that the firm does not issue preferred stocks. Therefore, the component WpsRps of the formula equals zero.
Calculations
Rd(1-T) = Cost of Debt * (1- Tax) = 6.50% * (1-30%) = 4.55%
Rs = Rs = RRF + (RPM * b) = 5.00% + (5.80% * 0.59) = 8.42%
Wd = (Short-term Debt + Long-term Debt) / (Book Value of Debt + MVA of Common Equity) =
650,250 / 5,586,700 = 11.64%
Wce: MVA of Common Equity / (Book Value of Debt + MVA of Common Equity) =
4,936,500 / 5,586,700 = 88.36%
Plugging in our calculations in the formula we derive that the WACC for firm X is:
WACC = (11.64%)*(4.55%) + 0 + (88.36%)*(8.42%) = 0.53% + 7.44% = 7.97%
This means that the weighted average cost the firm would face for a new, marginal dollar of capital is almost 8%.
Factors to be considered
There are several factors that are beyond a firm's control when calculating the WACC. These are the interest rates, the market risk premium and the taxes. All three factors affect the cost of debt and the cost of equity. For example, if interest rates rise, the cost of debt increases because the firm would have to pay the bond holders a higher interest rate to obtain debt capital. Similarly, if taxes increase, then cost of debt increases since tax percentage is used in the WACC calculations. Also, in regards to expected market risk premium, it is determined based on the risk aversion of the shareholders.
On the other hand, there are factors that a firm could control such as its capital structure policy, its dividend policy and its investment policy. All three policies aim to adjust for differences in project risk.
In conclusion, the Weighted Average Cost of Capital (WACC) is a factor to estimate a firm's value in order to achieve effective strategic decision making and performance evaluation by calculating a firm's cost of capital that weights each capital component proportionately. Failing to adjust for differences in project risk would lead a firm to undertake value-destroying projects and reject value-adding projects. Over time, the firm would become riskier, its WACC would increase and its shareholder value would decline.
Tags: equity
Frederick Poole