Weighted Average Cost of Capital

Capital Structure Theory

Before going towards the detail of weighted average cost of capital, some of the basic concepts in the capital structure theory should be cleared.

• Direct Claim Securities:

These are the securities that are backed by some real assets. These securities have further two types.

• Stock:

It is a legal piece of paper that reflects the ownership. If a company wants to raise money through equity, it issues stocks. Although all these purchased stocks are represented as liability of the company, which is shown on the liabilities side of the balance sheet.

• Bond:

The contractual paper that shows the debt for a longer duration and is legally secured is called bond. If a company desires to raise money through debt. Then it issues Bonds and these debt instruments are also shown on the liabilities side of the balance sheet.

• Equity Vs Debt:

If a company issues bonds to raise money through debt, then it must fix regular payments throughout the life of each bond. On the maturity date of bonds, the principal amount is returned back to the bond holder. If the company fails to pay the regular interest payments to the bondholder. Then it is being forced to close down and its assets would be sold to pay the liability of the bond holders.

On the other hand if money is raised through equity in the form of stock, then the company shares its ownership with the shareholder. In this case the company is not bound to pay a regular fix payment instead of paying dividends from the net profits of the company.

• Capital Structure:

A company raises capital through Equity Shares or debt (bonds) to make its operations in proper action. The proportionate combination of debt and equity is called capital structure of the company. Capital structure is a delicate matter for a company, because there are a lot of factors that are affected by the ratio of debt to equity.

The capital structure ratio is set on the basis of the strategy and financing needs of the company. So it can be changed from one period to the other. Also there are certain capital intensive industries that keep more proportion of debt than the actual equity. Some Muslims keep their capital structure purely equity based due to the forbiddance of the interest in their religion.

• Cost of Capital:

Companies maintain a proper capital structure for their smooth functioning. For this purpose they assure to have the lowest risk and higher profitability in order to capture the investors. This will help the company to get the money (through shares and bonds) at the minimum cost.  It is obvious that acquiring everything in this world bears some kind of risk. Same fact is applied to the acquired capital, and the companies struggle to pay the lowest possible cost for their capital.

Weighted Average Cost of Capital

When the company raises money through capital, it tries to acquire capital at the lowest possible cost. The Weighted Average Cost of Capital (WACC) is similar to the required rate of return that an investor expects from his investment in a certain project. It is also known as opportunity cost, because the investor sacrifices his second chance of investment that can provide him a certain return. But, the Weighted Average Cost of Capital has little difference from the ROR in a way that it is more practical.

This means that Weighted Average Cost of Capital takes into account the additional transaction cost and taxes. These taxes are corporate tax and income tax that is based on the net profit, and additional transactions of the financial securities, like issuing and marketing of shares and bonds, etc. The company has to pay these taxes to the government.

Three possible kinds of capital are involved in the Weighted Average Cost of Capital, which are given in the following formula.

WACC = rDXD + rEXE + rPXP

Weighted % Cost of Debt (rDXD):

rD shows the average required rate of return (ROR) of a rational investor  that is investing in the bonds. The proportion of the debt (bonds) to total capital is represented by XD.

Weighted % Cost of Common Equity (rEXE):

Similarly the average required ROR of the rational investor investing in common shares is represented by rE whereas the proportion of common shares to total capital is shown by XE.

Weighted % Cost of Preferred Equity (rPXP):

The rP represents the average required ROR of the rational investors, who are investing in the preferred equity investments. On the other hand the XP is the ratio of the preferred shares to the total capital.

rD (Required ROR or Cost of Debt):

As discussed earlier, the required rate of return (ROR) is actually the cost of debt, which is represented by rD. In case of a bond the overall return on the bond is given by the following formula.

Yield to Maturity (YTM) = Interest yield + Capital gain yield

When a company issues bonds in the market there are some transaction costs linked with it. These transaction costs are accounting, sales and marketing fees that are included in the PV formula of the market price of the bond so that the pre-tax cost of debt rD* is calculated. So, the following is used instead of the market price of a bond.

Net Proceeds = Market Price – Transaction Costs.

There is an advantage attached with the debt that the interest payment of debt is deducted from the tax payable.

After Tax Cost of Debt = rD = rD* (1-TC)

“TC” represents the marginal tax rate that is applied on the net income.

rE (Required ROR or Cost of Common Equity):

In case of common equity the required ROR is calculated by using the perpetuity formula, which gives the market price of equity.

PV = Po = DIV 1 / r

From the above formula “r” can be determined, which gives the required ROR.

r = DIV 1 / Po

rE (Required ROR or Cost of Preferred Equity):

There are certain floatation costs associated with the market price of the preferred equity, like printing, marketing, legal cost and brokerage fee, etc. So the actual price of the preferred stock is given by the following formula.

Present Value = Net Proceeds = Market Price – Floatation Costs.

Remember preferred dividends are not tax deductible, because these are paid from the net income.