Corporate Finance Basics

How do I calculate WACC?

In order to calculate a weighted average cost of capital there are a few pieces of information that we need to know:

TheW_d= The proportion of the financing taken on by debt (amount of capital taken from loans/initial investment)

The W_pfd= The proportion of the financing taken provided by preferred stock (amount of capital taken from preferred stock/initial investment)

The W_e= The proportion of the financing provided by equity (amount of capital raised by new equity/initial investment)

The after tax K_d= The cost of debt x ( 1- tax rate) or the interest rate that the bank requires

The K_pfd= dividend/share price

The K_e= R(r)+ Beta (Market Risk Premium)

The initial investment

The tax rate

We are now able to calculate the WACC which =

W_d(K_d)(1-t)+(W_pfd)(K_pfd) +(W_e)(K_e)

Here is a numerical example: We want to start a company that requires an initial investment of $100,000. Our company that will manufacutre plastic shower caddies will require use of all $100,000. We are able to take out a loan of $25,000 from a local bank; $50,000 by issuing common stock to family, friends, and professors; and $25,000 of preferred stock to a generous alumna of MHC. There is an 8% interest rate on our loan; and we agreed to pay our alumna 6% return. We do some research and see that a company who only manufactures plastic shower caddies has a beta of .85 with no outstanding debt. Our risk free rate is 4.4% and market risk premium is 6.6%. The tax rate is 30%. What is our required return on our investment that we will use to find a present value of our company, in other words, our WACC?

SOLUTION:

Wd= 25,000/100,000 = .25

W_e= 50,000/100,000 = .5

W_pfd= 25,000/100,000 = .25

K_d= .08

K_e= .044+.85(.066) = .10

K_pfd= .06

Now we can substitute into our equation:

WACC= (.25)(.08)(1-.3)+(.5)(.1)+(.25)(.06)

WACC= .014+.05+.015

= .079

= 7.9%

When finding a rate of return for an individual project, we must remember that WACC is only appropriate for an individual project when its risk is equal to the risk of the company as a whole. If there is added or subtracted risk to the firm from the project, the required return must be adjusted.

A new Beta for the project must be found by using the Hamada Equation:

Beta of assets= Beta of equity/ [1+(1-t)(D/E)]

Then a new return can be calculated using this new Beta:

Risk Adjusted Discount Rate= risk free rate+ (beta of assets)(market risk premium)

Why Calcluate WACC?

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This website was created in May 1999 byAlison Hirsch '01, and is maintained by Professor Satya Gabriel, of the Economics Department atMount Holyoke College