Weighted-Average Cost of Capital

Cost of Capital

The cost of capital is the rate of return the suppliers of capital (shareholders and debtholders) require as compensation for their capital contribution. In other words, the cost of capital can be seen as the opportunity cost of funds for the suppliers of the capital.

The cost of capital is composed of the cost of debt and the cost of equity. The cost of debt is riskier than the cost of equity and is sometimes secured with collateral. As such, debtholders have lower required rates of return than equity holders.

Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the company’s capital cost which is the rate of return that investors demand. It is usually estimated by computing the marginal cost of each of the various sources of capital for a company and then taking a weighted average of these costs.

Given the cost that a company incurs to raise additional capital, the WACC may also be referred to as the marginal cost of capital (MCC).

The formula for the WACC is:

$$ \begin{align*} WACC & =\left[\left(1-\text{Tax rate}\right)\times \text{Pre-tax cost of debt} \times \text{Weighting of debt}\right] \\ & +(\text{Cost of equity}\times \text{Weighing of equity}) \end{align*} $$

From the formula above:

• From the perspective of an issuer, the cost of debt is the required rate of return on debt financing. It is ussually an interest on the existing unsecured loans or bonds. However, a forward-looking measure of the cost of debt can be obtained by checking the rates on companies that recently borrowed. Lastly, if the interest expense is deductible, we decrease the nominal tax rate by \(\left(1-\text{Tax rate}\right)\).
• The weightings of debt and equity can be based on the market values proportions, or the target weights given by the management, which are based on book values proportions. Market values are commonly used because book value reflect the historical values while market values reflect current market prices.
• From the perspective of the issuer, the cost of equity is the required rate of return by the equity investors. Cost of equity is higher than the cost of debt and are not tax-deductible.

Example: Calculating the WACC

Assume that company XYZ has the following capital structure: 25% equity, 10% preferred stock, and 65% debt. Its marginal cost of equity is 12%, while its marginal cost of preferred stock is 9%. Lastly, its before-tax cost of debt is 7%. If the marginal tax rate is 35%, what is the WACC of company XYZ?

In this example, weighting of debt = 65%, cost of debt = 7%, tax rate = 35%, weighting of equity = 25%, and cost of debt = 12%.

And we know that,

$$ \begin{align*} WACC & =\left[\left(1-\text{Tax rate}\right)\times \text{Pre-tax cost of debt} \times \text{Weighting of debt}\right] \\ & +(\text{Cost of equity}\times \text{Weighing of equity}) \end{align*} $$

Therefore

$$ \begin{align*} WACC &=\left[\left(1-0.35\right)\left(0.07\times0.65\right)\right]+\left(0.12\times0.25\right) \\ & =0.0296+0.03 \\ & =0.0596 \text{ or } 5.96\% \end{align*} $$

Question

What is the weighted average cost of capital for a company if it has the following capital structure: 30% equity, 20% preferred stock, and 50% debt? Its marginal cost of equity is 11%, its marginal cost of preferred stock is 9%, its before-tax cost of debt is 8%, and its marginal tax rate is 40%.

1. 7.84%.
2. 5.7%.
3. 8.00%.

Solution

The correct answer is B.

$$ \begin{align*} WACC & =\left[\left(1-\text{Tax rate}\right)\times \text{Pre-tax cost of debt} \times \text{Weighting of debt}\right] \\ & +(\text{Cost of equity}\times \text{Weighing of equity}) \\
WACC & =[\left(1-0.4\right)\left(0.08\times0.5\right)+\left(0.11\times0.30\right) \\ & =0.024+0.033=0.057 \text{ or } 5.7\%
\end{align*} $$