The capital structure of a firm comprises of three financing components i.e. shareholders’ funds (including retained earnings), borrowed funds, and preference shareholders funds. All capital components have one feature in common i.e. the investors who provided the funds expect to receive return on their investments. The companies have to bear cost of using these funds as return to investors, which varies under different financing heads and also called specific costs. Cost of shareholders fund is the investors’ required rate of return and cost of borrowed funds is the after tax interest rate.
Though all of these costs are often looked and managed separately by the financial managers but it is also required to determine the overall cost of financing that is especially useful in establishing the viability of capitalizing upon the long-term investment opportunities. A project’s rate of return has to be in excess of the cost to finance it before allowing for being acceptable. The overall cost of capital is found by considering the weighted average cost of individual financing sources through taking into account their respective share in the overall capitalization. This by and large cost of financing is called weighted average cost of capital or WACC for which the terms of cost of capital, composite cost of capital, and combined cost of capital are also used.
The determination of WACC involves simple mathematical computations if the costs of individual financing sources are known. But determining the individual financing cost of each source requires some technical approaches of which a financial manager must be acquainted with for accurate extraction.
Measurement of Specific Costs
To attract the outside investment the company has to offer competitive rate of return to the investors. The company must earn more than the rate of return offered to investors in order to pay the dividend and to meet the costs. Shareholders’ required rate of return on invested funds is often determined through Capital Asset Pricing Model (CAPM) and Dividend Valuation Model (DVM) which require extensive calculations and are out of the scope of this article. But a bird eye view on CAPM and DVM techniques will be quite helpful in understanding the WACC. Formula to be used in CAPM is:
Ke = Rf + (Km – Rf) B
Ke = Cost of Equity Capital
Rf = The Rate of Return required on risk free investments
Km= The required Rate of Return on the market portfolio
B = The Beta coefficient
CAPM describes the relationship between the required return or cost of equity capital and the non-diversifiable risk of a firm measured by beta coefficient.
In DVM approach, the cost of equity is calculated on the basis of a required rate of return in terms of future dividends to be paid on the shares. The formula to be used is:
Ke = (D (1 + G ) / P0) + G
Ke = Cost of Equity
D = Dividend Per Share
P0 = Current Market Price
G = Growth Rate
The cost of borrowed funds is often known as the interest rate on loan sometimes called coupon rate. Because interest on loan is tax deductible expense and provides benefit in the form of tax reduction therefore cost of borrowed funds is determined as after tax cost. The formula to be used is:
Kd = Ki ( 1 – T)
Kd = Tax Adjusted Cost of Debt
Ki = Before Tax Cost of Debt
T = Tax Rate
Cost of Preference Shareholders’ funds is the rate of dividend to be paid on the preference shares. However, unlike interest payments on debt, dividend payable on preference shares is not tax deductible because preference dividend is not a charge on earnings or an item of expenditure; it is an appropriation of earnings. In other words, they are paid out of after tax earnings of the company. Therefore, no adjustment is required for taxes while computing the cost of preference capital.[sky]
Determination of specific costs requires more complex calculations if the instruments are convertible, redeemable, callable, or floatation costs and dividend taxes exist.
Suppose a firm has below mentioned Capital Structure:
Equity Capital $100,000
Preference Share $70,000
Other information is:
Risk free rate of return 8%
Market Rate of Return 12%
Beta Coefficient 1.5
Before Tax Cost of Debt 11%
Tax Rate 35%
Preference Share Dividend 10%
Required: Determine WACC
Specific Costs of each component are determined.
Cost of Equity = Ke = 8% + (12% – 8%) 1.5 = 14 %
Cost of Debt = Kd = 11% (1-35%) = 7.15% = Round 7%
Cost of P. Stock = Kp = 10%
Weighted Average Cost of Capital
WACC = $27,005 / $ 250,000 = 0.108 = 11% (Approx)
Some difficulties with calculation of WACC are that often some reliable and concrete information is not available therefore it represents good approximation of the cost of capital. For example required rate of return to investors varies according to their risk preferences and it is often difficult to determine the actual return. Moreover return to the equity holders solely depends upon the discretion of the company management.
The considerable significance of cost of capital in terms of its practical utility notwithstanding, it is probably the most controversial topic in financial management. There are varying opinions as to how this can be computed. In view of the crucial operational significance of this concept, the general framework for computation of WACC remains in focus. The cost of capital thus provides a rational mechanism for making optimum investment decisions. In brief, the cost of capital is important because of its practical utility as an acceptance-rejection decision criterion.