I would ask Peter Lynch a question on the weighted average cost of capital (WACC). The reason is that it is used to calculate the firm’s average cost after all the tax has been deducted. In addition, WACC is used in discounting cash flows for calculation of NPV and effectively the valuations for business analysis and investment.
A corporation has one million shares of common stock currently trading at $30 per share. Current risk free rate is 4%, market risk premium is 8% and the company has a beta of 1.2.
It also has 50,000 bonds with of $1,000 par paying 10% coupon annually maturing in 20 years currently trading at $950.
The tax rate is 30%. Calculate the weighted average cost of capital.
SolutionFirst we need to calculate the weights of debt and equity.
Market Value of Equity = 1,000,000 × $30 = $30,000,000Market Value of Debt = 50,000 × $950 = $47,500,000Total Market Value of Debt and Equity = $77,500,000Weight of Equity = $30,000,000 / $77,500,000 = 38.71%Weight of Debt = $47,500,000 / $77,500,000 = 61.29%Weight of Debt can be calculated as 100% minus cost of equity = 100% − 38.71% = 61.29%
Second step in our solution is to calculate the cost of equity.
With the given data we can use capital asset pricing model (CAPM) to calculate cost of equity as follows:
Cost of Equity = Risk Free Eate + Beta × Market Risk Premium = 4% + 1.2 × 8% = 13.6%
We also, need to find the cost of debt.
Cost of debt is equal to the yield to maturity of the bonds.
With the given data, we can find that yield to maturity is 10.61%.
After tax cost of debt is hence 10.61% × (1 − 30%) = 7.427%
Hence, WACC = 38.71% × 13.6% + 61.29% × 7.427% = 9.8166%
The potential issues in using varying techniques for cost of capital for different divisions are used to calculate the average risks faced by the corporation. If then different operating divisions were used, then definitely, separate cost of capital figures must effectively be utilized. Hence, the use of overall cost of capital will definitely become inappropriate.
If the overall company weighted average cost of capital (WACC) were used as the hurdle rate for all divisions, would more conservative or riskier divisions get a greater share of capital?
In this order, if the single hurdles were used this will lead to the riskier divisions receiving more funds as a share of the capital. This is because the returns would exceed the hurdle rate. This will lead to unprofitable projects on a risk-adjusted basis. Hence, the problem witnessed in estimating the cost of capital for a division is that it definitely has rare securities traded on the market. Consequently, this leads to a difficulty in observing the market’s valuation and the risk of the division.
What are two techniques that you could use to develop a rough estimate for each division’s cost of capital?
The techniques are; pure play proxy ultimately for the division and second is the use of subjective adjustments for the overall firm hurdle rate. In addition, this definitely should be based on the perceived risk associated by the division.
References
Pratt, S. P. (2002). Cost of capital: Estimation and applications. Hoboken, N.J: John Wiley & Sons.
Pratt, S. P., & Grabowski, R. J. (2008). Cost of capital: Applications and examples. Hoboken, N.J: John Wiley & Sons.
