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Explaining Weighted Average Cost of Capital


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Research Weighted Average Cost of Capital
 and discuss in 1000 words.

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Weighted Average Cost of Capital

INTRODUCTION

The weighted average cost of capital (WACC) is used in many finance applications, but this computation is far from as precise as the novice might think or without controversy (Nantell & Carlson, 1975). Some argue that WACC is only as good as the assumptions used in the computation and users regularly question the assumptions. WACC is used in a range of application in finance and so understanding its limitations and strengths is important. For instance, WACC is used as a minimum threshold for capital projects, as baseline for a hurdle rate for economic profit computations, for comparing to other industry participants and for comparison against return on assets. This computation is relatively simple once the ingredients have been identified and most beginning students can accomplish the "math tasks" accurately. However, deciding the ingredients is the difficult aspect.

INGREDIENTS

The WACC uses two components, the cost of debt and the cost of equity and blend them, based on their relative size to an average for the firm overall. Within debt and equity, the debt component averages the cost of debt, generally the after tax interest rate presuming interest is deductible, weighted by the size of the debt instruments held. The equity element ignores taxes, since dividends are not tax deductible, and weights the cost of equity for the various securities issued.

PROBLEMS

Leverage.

One of the problems is the leverage issue. That is, the proportion of funds obtained from debt may shift. This tips the "weighting" either more towards debt (if new debt is obtained or equity is contracted) ...

Solution Summary

Your draft is 932 words and four scholarly references. This discussion claims that while the math computation is relatively straight-forward, finding the assumptions for interest rate, annuity for equity and tax rates are far from obvious. Examples are given.

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Weighted Average Cost of Capital (WACC) explained in this solution

ABC Co. is estimating its WACC. Its target capital is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semi-annully, a current maturity of 20 years, and sell for $1,000. The company could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. ABC Company's beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. ABC Co. is a constant-growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find common stock (rs). The firm's marginal tax rate is 40 percent.

What is ABC Co. component cost of debt?
Cost of preferred stock?
Cost of common stock (rs) using the CAPM approach?
Cost of common stock (rs) using the DCF approach?
Cost of common stock using the bond-yield-plus-risk-premium approach?
What is ABC Co. WACC?

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