In Weighted Average Cost of Capital, we discussed what Weighted Average Cost of Capital was along with some of the basic examples that helped us figure out WACC of a particular company. In this article, I will show an intermediate example of Weighted Average Cost of Capital calculation. The idea behind this article is that you will be able to calculate WACC for any given company for the provided scenario / example.
Problem 1:
Indews Financial Corp. has 20 million shares of common stock outstanding and is currently trading at $25 / share. Firm's $180 million debt issued at face value is now trading at 95% of its value. Indews Financial Corp. has a cost of debt of 10% before taxes, and the required return for its stockholders is 20%. What is the WACC of Indews Financial Corp? The Company has a tax rate of 40%.
In the above problem we have been given the following variables:
Outstanding Common Stock: 20,000,000
Current Price of Common Stock: $25
Face Value of Debt: $180,000,000
Current Value of Debt: 95% of Face Value
Cost of Debt: 10%
Cost of Equity: 20%
Taxes: 40%
Calculations
Calculating Market Value of Equity
We know that there are 20 Million Shares Outstanding, and each has current price of $25. So, the market value of all common stocks is:
Market Value of Common Stocks: $25 * 20,000,000
Market Value of Common Stocks: $500,000,000
Calculating Market Value of Debt
The debt was issued at a face value of $180,000,000. The current market value of debt is 95% of the issued face value:
Market Value of Debt: $180,000,000 * .95
Market Value of Debt: $171,000,000
Calculating Cost of Debt
We know that the cost of debt provided to us was BEFORE Taxes. So, after-tax cost of debt would be
After-Tax Cost of Debt: 10% * (1-.40) = .06
After-Tax Cost of Debt: 6%
We now have the following calculated variables:
Market Value of Equity: $500,000,000
Market Value of Debt: $171,000,000
After-Tax Cost of Debt: 6%
Cost of Equity: 20%
Weight of Debt from the above variables would be: $171,000,000 / ($500,000,000+171,000,000)
Weight of Debt: .25* or 25%
Weight of Equity: $500,000,000 / ($500,000,000+171,000,000)
Weight of Equity: .75* or 75%
The Weight of Debt and the Weight of Equity have been rounded to 2 decimals for the sake of simplicty.
Calculating Weighted Average Cost of Capital
We know that Weighted Average Cost of Capital is Weight of Debt * Cost of Debt After Tax + Weight of Equity * Cost of Equity
= .25*.06 + .75*.20
= .015 + .15
= .165
= 16.5%
The Weighted Average Cost of Capital for Indews Financial Corp. was 16.5%.
Problem 2:
The expected return on the market is 13%, with a risk-free rate of 7%, along with a corporate tax of 35%. Ryzone Financial Inc. has a beta of 1.29, and a Debt-Equity Ratio of 1. What is Ryzone Financial Inc's Cost of Equity and the Weighted Average Cost of Capital, when the firm has a before-tax cost of debt of 7%?
From the above problem we can extract the following variables:
Expected Market Return: 13%
Risk Free Rate: 7%
Corporte Tax: 35%
Beta: 1.29
Debt-Equity Rate: 1
Before Tax Cost of Debt: 7%
Required Calculations: Required Rate of Return or Cost of Equity and Weighted Average Cost of Capital
We can calculate the Cost of Equity (Required Rate of Return) through Capital Asset Pricing Model (CAPM).
The formula for Capital Asset Pricing Model is Risk-free Rate + (Market Return * Risk-Free Rate) * Beta
So, the Required Rate of Return or Cost of Equity would be:
=.07 + (.13-.07)*1.29
=.07 + .0774
=.1474 or 14.74%
Cost of Equity = 14.74%
Since the Debt-Equity Ratio is 1, Ryzone Financial Inc. has equal weights of debt and equity.
:
The Calculation of Weighted Average Cost of Capital (WACC) would be :
= .5 * [.07(1-.35)] + .5 (.1474)
= .02275 + .0737
= .09645
= 9.65%
The Weighted Average Cost of Capital for Ryzone Financial Inc. would be 9.65% or 9.645% to be precise.
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