Question

How to calculate the WACC? How to treat the tax consequence of debt in the calculation? Example please, No Excel

Answer 1

How to calculate the WACC?

Formula for calculating WACC = Kd * Wd + Ke * We + Kp * Wp

Kd = after tax cost of debt

Wd = Weight of Debt

Ke = Cost of Equity

We = Weight of Equity

Kp = Cost of Preference shares

Wp = Weight of Preference Shares

Note: Reason for taking after tax cost for the Deb for calculating WACC

For debt capital company need to pay interest and that interest payment reduces the taxable profit. Accordingly our tax liability reduces to that extend. Since interest payment provides tax shield we consider after tax cost of debt.

How to calculated after tax cost of debt (Kd)

Formula for calculating after tax cost of Debt = Interest rate * (1 – Tax Rate)

Example

Type of Capital	Cost before Tax	Amount
Debt	8%	$1,160
Equity	17%	$2,304
Total Capital (Debt capital + Equity Capital)		$3,464

Tax rate = 25%

Calculations

Kd (After tax cost of debt)

Cost debt (before tax) = 8%

Tax rate = 25%

After tax cost of debt = cost of debt before tax * (1- tax rate)

                                                = 8%*(1-.25)

                                                =6%

Ke (Cost of Equity)

Cost of equity = 17% (given in the problem)

Weight of Equity and Debt

Wd (Weight of Debt) = (Total Debt ÷ Total Capital) x 100

                                    = ($1,160 ÷ $3,464) x 100

                                    =33.49%

We (Weight of Equity) = (Total Equity ÷ Total Capital) x 100

                                    = ($2,304 ÷ $3,464) x 100

                                    = 66.51%

Total Debt = $1,160 (given in problem)

Total Capital = Total Equity + Total Debt

                        =$2,304+$1,160

                        =$3,464

Final Answer

Formula for calculating WACC = Kd * Wd + Ke * Wd

Kd = after tax cost of debt = 6%

Wd = Weight of Debt = 33.49%

Ke = Cost of Equity = 17%

We = Weight of Equity = 66.51%

WACC = (6% x 33.49%) + (17% x 66.51%)

            = (.06 x .3349) + (.17 x .6651)

            = 13.32%