Question

Discus the three pairs of elements of the weighted average cost of capital formula. What does the WACC denote? (For example, what does the WACC = 9.7% suggest to the analyst?) Which WACC element, if any, is calculated “after tax”? Why? What does this suggest about using this asset class, courtesy of the US government?

Answer 1

A)

For firm, to conduct its day to day operations,to achieve its long term sales or revenue targets, to acquire any fixed assets, capital is very much required.The sources of a capital for a firm can be broadly categorized into,

1) Issuing common stock

2) Issuing preferred stock

3) Issuing bonds

4) other long term debt

If company issues common stock or preferred stock for capital requirements, it has to pay the returns to the shareholders who holds company common or preferred stock. If it issues bonds or takes long term debt, it has to pay the interest to the debt holders.Whatever the company needs to pay to the shareholders or debt holders becomes cost to the company and so it is called cost of capital.

But a company's entire capital cannot be funded by solely any single option. It can be a mix of common stock, preferred stock and debt.So, we calculate weighted average based on their percentage in total capital i.e called WACC

The cost towards common stock is called cost of equity(COE)

The cost towards preferred stock is called cost of preferred stock(COP)

The cost towards debt is called cost of debt(COD)

WACC = W_e*COE +  W_p *COP + W_d * COD * (1-Tax)

So, the 9.7% of WACC signifies the weighted average cost of capital that the firm calculated using the weighted average of COE and COP and COD

B)

Cost of Debt part of WACC is calculated after tax

C)

Because,In case of debt, you need to pay the interest to debt holders, so your profit will be reduced by the amount of interest you paid. Usually you need to pay the tax on profit, since the interest component is decreasing your profit here, you will be saving the tax on that component.So to include net effect of tax saved, the after tax cost of debt will be used

eg: if profit before tax 100, tax 30% then tax = 100*30% = 30

if profit before tax 100,interest 20, tax = 30% then tax = (100-20)*30% = 24

So, you have saved around $6 that you need to pay as tax, this effect is included as after tax cost of debt in WACC calculations