Question

Describe the weighted average cost of capital. How do firms use the weighted average cost of capital for decision making? How are the costs of debt and equity calculated?

How are the costs of debt and equity calculated?

Answer 1

Weighted average cost of capital (WACC) is the average rate of return a company expects to compensate all its different investors. The weights are the fraction of each financing source in the company's target capital structure.

Here is the basic formula for weighted average cost of capital:

WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate

A company is typically financed using a combination of debt (bonds) and equity (stocks). Because a company may receive more funding from one source than another, we calculate a weighted average to find out how expensive it is for a company to raise the funds needed to buy buildings, equipment, and inventory.

Cost of Debt

Companies sometimes take out loans or issue bonds to finance operations. The cost of any loan is represented by the interest rate charged by the lender. For example, a one-year, $1,000 loan with a 5% interest rate "costs" the borrower a total of $50, or 5% of $1,000. A $1,000 bond with a 5% coupon costs the borrower the same amount.

The cost of debt does not represent just one loan or bond. Cost of debt theoretically shows the current market rate the company is paying on its debt. However, the real cost of debt is not necessarily equal to the total interest paid, because the company is able to benefit from tax deductions on interest paid. The real cost of debt is equal to interest paid less any tax deductions on interest paid.

The dividends paid on preferred stock are considered a cost of debt, even though preferred shares are technically a type of equity ownership.

Cost of Equity

Compared to cost of debt, the cost of equity is complicated to estimate. Shareholders do not explicitly demand a certain rate on their capital in the way bondholders or other creditors do; common stock does not have a required interest rate.

Shareholders do expect a return, however, and if the company fails to provide it, shareholders dump the stock and harm the company's value. Thus, the cost of equity is the required return necessary to satisfy equity investors.

The most common method used to calculate cost of equity is known as the capital asset pricing model, or CAPM. This involves finding the premium on company stock required to make it more attractive than a risk-free investment, such as U.S. Treasurys, after accounting for market risk and unsystematic risk

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