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CALCULATING COST OF CAPITAL

Numerical Example :

Moon Investments Balance Sheet


shows:

Bonds $ 200,000
Common shares $ 200,000
Retained Earnings $ 100,000
-------------
$ 500,000
=========

Bonds:
• Annual interest rate 6%
• Years to maturity is 9 years

Common shares:
• Shares held 100,000
• Current share price $5
• Market return over next year 12%
• Beta (somewhat risky) 1.15
• Treasury bills currently yield 4%

• Tax rate 25%

Calculation of Cost of Capital:


First, determine market values

• Bonds:
FV = $200,000
Interest per year = $200,000 x 0.06 = $12,000
N (number of years) = 9
i (interest rate) = 6%
PV (present value of the bonds)

S
P = ----------
(1+rt)

$ 200,000
P = -------------
[1 + (0.06)9]

$ 200,000
P = --------------
1.54

P = $129,870.12

Let’s check it out:


Interest per year = $129,870.12 x 0.06 = $7,792.21
Interest for nine years = $ 7,792.21 x 9 = $ 70,129.88

Amount to be paid at maturity =


$ 129,870.12 + $ 70,129.88 = $ 200,000 (this is the face
value).

• Common Shares:
100,000 shares x $ 5 = $ 500,000

Second, determine weightings based on market


values:
Bonds $ 129,870 0.2062
Common shares $ 500,000 0.7938
--------------- ---------
$ 629,870 1.0000

(should always be 1)

Third, determine costs:


• Common shares:
Rate of return = Risk-free rate (treasury bills rate) +
[market return over next year – risk free rate]Beta
= 0.04 +(0.12 -0.04)1.15
= 0.04 + 0.092
= 0.132

• Bonds:
PV = $ 129,870
FV = $ 200,000
i (after tax) = $ 12,000 (1 – 0.25)
= $ 12,000 x 0.75
= $ 9,000
Effective rate = $ 9,000/$ 200,000 = 0.045 or 4.5%

Finally, determine cost of capital


Weightings Costs Weightings x Costs
Bonds 0.2062 0.045 0.0093
Common Shares 0.7938 0.132 0.1048
---------
0.1141
======

Cost of Capital = 11.41%

2.

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

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

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

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

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

The Kpfd= dividend/share price

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

The initial investment

The tax rate

We are now able to calculate the WACC which =

Wd(Kd)(1-t)+(Wpfd)(Kpfd) +(We)(Ke)
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

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

Wpfd= 25,000/100,000 = .25

Kd= .08

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

Kpfd= .06

Now we can substitute into our equation:

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

WACC= .014+.05+.015

= .079

= 7.9%