In essence, the weighted-average cost of capital (WACC) is a simple concept. An entity's cost of capital is an average of the costs of all the finance sources within the company weighted by the total market value of each source.
Consider, for example, a company with three sources of finance: equity, preference shares and debt (see table 1). The company's WACC would be calculated as follows: WACC = (17% x 23 / 42) + (13% x 5 / 42) + (6% x 14 / 42) = 12.86%.
Note that the cost of debt should be post tax, as a company is granted tax relief on interest it pays. Although a WACC formula is included in the formula sheet provided in the exam, a weighted-average calculation is something that candidates should have come across at school and be able to do without referring to the sheet.
Students must check that they can quickly and accurately input the calculation above into their calculator and produce the correct answer. It is wise to make a mental estimate whenever you perform any such calculation. You will then notice if the calculator produces an odd result and so have a chance to correct it. In this case, we know that the average must lie somewhere between the highest and lowest costs of finance in the table. Equally, because the company has more equity finance than any other type, the result should be closer to 17 per cent than six per cent. So when we calculate 12.86 per cent we can be confident that it is probably correct.
The WACC calculated can then be used as the discount rate when appraising a potential project, as long as the following two conditions apply:
* The project carries a similar business risk to that of the firm's current operations.
* Undertaking the project will not require significant new funds to be raised that may affect the company's financial risk.
When calculating a WACC we make the important assumption that it is the company that's financed, not individual projects. Hence all of the company's finance sources are pooled and the average cost of the pool--the WACC--is used as the company's discount rate and is applied to all relevant projects. This is known as the pooling assumption.
The weighty issue is that students must be able to calculate the cost of equity and the cost of debt. Unfortunately, there are numerous techniques to learn. Individually, each one is not particularly difficult, but candidates who fail to invest enough time in this area will get them muddled and fail to identify the correct approach called for by a particular situation.
The following two scenarios will demonstrate the key techniques required.
The AG Company is financed using the following methods:
* Equity. The company has 20 million shares, which are trading at $3.70 per share. It has an equity beta of 1.15.
* Preference shares. The company has ten million $1 seven per cent preference shares, which are trading at $0.91.
* Debt. AG has $30m par value of eight per cent debentures, which are redeemable at par in six years' time. The debentures are trading at $101 per cent.
The return on the market is 11 per cent, the return on government stock is five per cent and the corporate tax rate is 30 per cent.
You are required to calculate the WACC of the AG Company.
Solution to scenario one
The cost of equity can be calculated using either the dividend valuation model (DVM) or the capital asset pricing model (CAPM). An exam question is unlikely to indicate which method should be used, so students need to be able to decide according to the information that is provided. CAPM should be used in this case, as AG's equity beta has been provided. The CAPM formula provided is [k.sub.e] = [R.sub.f] + ([R.sub.m] - [R.sub.f])[beta] where:
* [k.sub.e] is the cost of equity.
* [R.sub.m] is the return on the market (given in the scenario as 11 per cent). …