Question

Select all options that describe the Weighted Average Cost of Capital (WACC) for a company:

	The WACC represents the overall cost of the company's long term financing. It also represents the required return on the company's assets.
	The WACC for the company is equal to the cost of equity plus the cost of debt. This total cost of capital reflects the price of a single share in the company.
	The WACC for the company is equal to the cost of equity plus the cost of debt. Interest on debt must always be paid so the cost of debt must always be more than the WACC.
	The WACC is a measure of the profitability of the company. It represents the amount of surplus capital the company generates after it has paid interest and debt repayments.
	The WACC is an average of the cost of debt and equity capital in the company. The costs of debt and equity are scaled depending on the proportion of each type of funding in the company.

The following data applies to Micro Advanced Developers (MAD).

Debt	Equity
market value of debt = $169,253	market value of equity = $151,961
time to maturity of debt = 12 years	risk free rate = 4.9% pa
coupon rate = 6.7% pa paid semi-annually	market risk premium = 8.2% pa
face value = $200,000	DDD beta = 1.03

As a financial manager you have been given the task of calculating the company's weighted average cost of capital (WACC). Ignore the effect of taxes.

a)Firstly, you realise that the cost of debt is needed. Calculate the cost of debt for MAD. You may give your answer as a percentage per annum to the nearest percent or use linear interpolation or a financial calculator to give a more accurate result.

Cost of debt =  % pa

b)Secondly, the cost of equity must also be identified. Calculate the cost of equity for MAD. Give your answer as a percentage per annum to 1 decimal place.

Cost of equity =  % pa

c)Finally, calculate the weighted average cost of capital for MAD. Give your answer as a percentage per annum to 1 decimal place.

Weighted average cost of capital =  % pa

Answer 1

Answer to 1st question

Option-1 The WACC represents the overall cost of the company's long term financing. It also represents the required return on the company's assets.

Option 5 The WACC is an average of the cost of debt and equity capital in the company. The costs of debt and equity are scaled depending on the proportion of each type of funding in the company.

Option 1 and option 5 gives the correct definition of WACC. The other options are not correct.

Answer to 2nd Question

(a) Cost of debt (Kd) = Interest / Market value of debt = (200000*6.7%)/159253 = 7.9%

(b)  Cost of equity (Ke) = Risk free rate + Beta*(Market rate-Risk free rate) = 4.9%+1.03*(8.2%-4.9%) = 4.9%+3.4% = 8.3%

(c) Weight of Debt (Wd) = (169253/321214) = 52.7%
Weight of equity (We) = (151961/321214) = 47.3%

WACC = (We*Ke) + (Wd*Kd) = (47.3%*8.3%)+(52.7%*7.9%) = 3.9%+4.2% = 8.1%