WACC and Cost of Capital Calculation Examples

Capital Budgeting and Cost of Capital Analysis

13) The company cost of capital may be an inappropriate discount rate for a capital budgeting proposal if the proposal has a different degree of risk. (ch13)

Calculating Weighted Average Cost of Capital (WACC)

1) The company cost of capital for a firm with a 65/35 debt/equity split, an 8% before-tax cost of debt, a 15% cost of equity, and a 35% tax rate would be:

Calculation: 0.65 × (1 - 35%) × 8% + 0.35 × 15% = 8.63%

Determining After-Tax Cost of Debt

2) The firm has 7,500 bonds outstanding with a face value of $1,000 per bond. The bonds carry a 7% coupon, pay interest semiannually, and mature in 8 years. The bonds are selling at 98% of face value. The company's tax rate is 34%. What is the firm's after-tax cost of debt?

• Settlement date: 1/1/00
• Maturity date: 1/1/08
• Annual coupon rate: 7%
• Bond price (% of par): 98
• Face value (% of par): 100
• Coupons per year: 2

Using the Excel YIELD function, the yield is 7.33%. The after-tax cost is: 7.33% × (1 - tax rate).

Cost of Preferred Stock

3) What is the cost of preferred stock that sells for $10 per share and offers a $1.20 dividend?

Calculation: $1.20 / $10.00 = 12%

Comprehensive WACC Calculation

4) What is the WACC for a firm using 55% equity with a required return of 15%, 35% debt with a required return of 8%, 10% preferred stock with a required return of 10%, and a tax rate of 35%?

WACC = (0.35 × (1 - 0.35) × 0.08) + (0.1 × 0.1) + (0.55 × 0.15) = 1.82% + 1.0% + 8.25% = 11.07%

Note: Make sure debt is calculated first (0.35) and the tax rate (1 - 0.35) is applied correctly.

Cost of Equity via CAPM

5) According to CAPM estimates, what is the cost of equity for a firm with a beta of 1.5 when the risk-free interest rate is 6% and the expected return on the market portfolio is 15%?

Expected return on stock = 6% + 1.5(15% - 6%) = 6% + 13.5% = 19.5%

Cost of Equity via Dividend Growth Model

6) What return on equity do investors seem to expect for a firm with a $55 share price, an expected dividend of $5.50, a beta of 0.9, and a constant growth rate of 5.5%?

Formula: (Dividend / Price) + Growth = ($5.50 / $55.00) + 5.5% = 10% + 5.5% = 15.5%

Debt-to-Value Ratio for WACC Purposes

7) Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock trades for $3.00 per share. It also has $2 million in face value of debt that trades at 90% of par. What is its ratio of debt to value for WACC purposes?

• Market Value of Equity: 2 million shares × $3.00 = $6,000,000
• Market Value of Debt: $2 million debt × 90% = $1,800,000
• Total Value: $7,800,000

Debt-to-Value Ratio: $1.8 million / $7.8 million = 23%

Case Study: Peter's Audio Shop WACC

8) Peter's Audio Shop has a before-tax cost of debt of 7%, a cost of equity of 11%, and a cost of preferred stock of 8%. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102% of face value. The tax rate is 34%. What is the weighted average cost of capital for Peter's Audio Shop?

• Debt: $500,000 × 1.02 = $510,000 ($0.51m)
• Preferred Stock: 40,000 × $34 = $1,360,000 ($1.36m)
• Common Equity: 104,000 × $20 = $2,080,000 ($2.08m)
• Total Market Value: $0.51m + $1.36m + $2.08m = $3.95m