Question

2. Find the weighted average cost of capital for COSTCO

a) explain how the WACC is calculated

b) explain the WACC in the context of hurdle rate, return on invested capital(ROIC), an optimal capital structure, and an optimal capital budget.

Answer 1

A) WACC is the weighted average of the cost of a company’s debt and the cost of its equity. Weighted Average Cost of Capital analysis assumes that capital markets (both debt and equity) in any given industry require returns commensurate with the perceived riskiness of their investments .

WACC Formula = (E/V * Ke) + (D/V) * Kd * (1 – Tax rate)

• E = Market Value of Equity
• V = Total market value of equity & debt
• Ke = Cost of Equity
• D = Market Value of Debt
• Kd = Cost of Debt
• Tax Rate = Corporate Tax Rate

B)

• The hurdle rate is a benchmark for the rate if return that is set by an investor or manager. On the other hand the weighted average cost of capital (WACC) is the cost of the capital. This includes all sources of capital.
• A company creates value for its investor only if its ROIC is higher than its weighted average cost of capital (WACC). WACC measures the required return on the company's debt and equity. It also takes into account the risk of company's operations & its use of debt.
• The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm's future cash flows, discounted by the WACC.
• The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm's future cash flows, discounted by the WACC.