WACC Calculations
WACC by Gordon Valuation:
Cost of Equity (Ke):
Formula = Ke = [dividend for the year (1 + growth) / Market value of share] + growth
Ke = [RM 0.20 (1 + 10%) / RM 4.20] + 10%
Ke = 15.2%
Value of Equity (Ve):
Vie = Number of shares in issue x market value of the share
Ve = 1,000,000 x RM 4.20 = RM 4,200,000
Cost of Debt (Kd):
Formula = Kd = Interest rate / Market Value of debt
Kd = 10% / 1,000,000 = 0.00001
Value of Debt (Vd):
Vd = 1,000,000 x 1.125
Vd = 1,125,000
WACC = [Ve/Ve+Vd] x Ke + [Vd/Ve+Vd] x Kd
WACC = [4,200,000/4,200,000+1,125,000] x 15.2% + [1,125,000/4,200,000+1,125,000] x 0.00001
WACC = 0.1198 + 0.0000021
WACC = 0.1198 => let say 12%
WACC by CAPM:
Cost of Equity (Ke):
Ke = Risk Free rate + Beta (Expected rate of return – risk free rate)
Ke = 4% + 1.4 (14% - 4%)
Ke = 18%
WACC = [Ve/Ve+Vd] x Ke + [Vd/Ve+Vd] x Kd
WACC = [4,200,000/4,200,000+1,125,000] x 18% + [1,125,000/4,200,000+1,125,000] x 0.00001
WACC = 0.1419 + 0.000021
WACC = 0.1419 =. Let say 14%
In dividend growth model to calculate WACC, management use the growth of the past dividends as the indicator to access the future growth in the dividends. However, the future is uncertain, and it is highly probable that the trend of the dividends will change in the future. Therefore, the estimations on the basis of growth model can be risky for the long term projects. Another disadvantage of using the growth model is that it is highly probable that the market price of a share is a manipulated market price by using different financing methods. Another disadvantage of using the dividend growth model is that the growth in dividend can be different from the growth of the company that can lead to the wrong decision making for a long life projects. However, the main advantage of the dividend growth model is that it focuses on the earning and the dividends of the business. Moreover, it is easier to calculate and understand as compared to the CAPM method. (Investopedia, 2009)
The main advantage of the CAPM method for evaluating the WACC is that it accumulates all the industry and business risks in the calculation of the WACC. However, it is very important for the management to calculate the correct beta and other industry risks for the calculation of the CAPM. The main disadvantage of the CAPM method is that it is difficult to access the actual or exact beta, systematic and unsystematic risks easily. Moreover, the main drawback of CAPM is that the calculated WACC can be used in the decision making of only one accounting period. The risks and interest rates in the industry change with the trend and behavior of the market. Therefore, it is very difficult to access proper WACC for longer term projects on the basis of one year assessments. CAPM is not useful for those investors who don’t like to keep the large portfolio of shares. CAPM suggests diversifying the risk and to invest in different businesses to reduce the risk for the investors. In the case of the investor, it ignores the effect of taxation. One of the advantages of CAPM is its flexibility. Different types of risks can be obtained by the businesses working in the same sectors and management can use it in calculating the CAPM. (Xi, 2014)
References
Investopedia. 2009. Gordon Growth Model Definition | Investopedia. [online] Available at:
http://www.investopedia.com/terms/g/gordongrowthmodel.asp [Accessed: 2 Apr 2014]
Xi, T. 2014. The Advantages & Disadvantage of CAPM | eHow. [online] Available at:
http://www.ehow.com/info_8053939_advantages-disadvantage-capm.html [Accessed: 2 Apr 2014].
