WACC – Weighted Average Cost of Capital

Beta Coefficient                     1.5

Before Tax Cost of Debt         11%

Tax Rate                                 35%

Preference Share Dividend    10%

Required: Determine WACC

Solution:

Specific Costs of each component are determined.

Cost of Equity         = Ke = 8% + (12% – 8%) 1.5  = 14 %

Cost of Debt           = Kd = 11% (1-35%) = 7.15% = Round 7%

Cost of P. Stock      = Kp = 10%

Weighted Average Cost of Capital

WACC = $27,005 / $ 250,000 = 0.108 = 11% (Approx)

Some difficulties with calculation of WACC are that often some reliable and concrete information is not available therefore it represents good approximation of the cost of capital. For example required rate of return to investors varies according to their risk preferences and it is often difficult to determine the actual return. Moreover return to the equity holders solely depends upon the discretion of the company management.

The considerable significance of cost of capital in terms of its practical utility notwithstanding, it is probably the most controversial topic in financial management. There are varying opinions as to how this can be computed. In view of the crucial operational significance of this concept, the general framework for computation of WACC remains in focus. The cost of capital thus provides a rational mechanism for making optimum investment decisions. In brief, the cost of capital is important because of its practical utility as an acceptance-rejection decision criterion.