This document discusses weighted average cost of capital (WACC) which is a calculation of a firm's cost of capital considering the costs of the different components of the firm's capital structure (debt, equity, preference shares). It defines WACC and explains its importance as the minimum return a firm needs to earn on new projects/investments to break even. The document also outlines how to calculate WACC and the costs of each capital component (cost of equity using CAPM, cost of debt, cost of preference shares). It discusses how WACC is used as a benchmark for projects, in determining leverage limits, for valuation, and in discounting cash flows in a DCF analysis.

1. STRATEGIC FINANCIAL
MANAGEMENT
COST OF CAPITAL, COST OF DEBT, COST OF EQUITY, COST OF PREFERENCE
SHARES, WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Dayana Mastura Baharudin

4. Creditor Hierarchy

5. Cost of Capital Definition

6. Cost of Capital - Objective

7. Cost of Capital - Components

11. Kp

12. Weighted Average Cost of Capital (WACC)
1
WACC or Weighted
Average Cost of
Capital is the
“effective” or “net”
cost that a business
bears for maintaining
its capital whether
equity or debt.
2
The weight refers to
the relative
proportion of the
capital components
in the total capital of
the business.
3
The cost of total
funds of a business
cannot be known by
studying the capital
components in
isolation.
4
The true picture
emerges when they
are studied
collectively under a
single lens. That is
exactly the purpose
of a WACC
calculation.
5
After all, the value of
any enterprise is the
combined effect of
both equity and debt
on its balance sheet.
6
WACC calculation
aggregates the
various sources of
funds. This provides
a singular yet all-
encompassing
number to judge the
cost-effectiveness.

13. WACC
calculation
WACC calculation is the computation of
the cost of the overall capital of a
business.
The capital structure of a business
comprises components of debt and
equity which have been procured at
different costs.
The calculation of WACC gives an
aggregated and all-inclusive cost that
is computed after taking into account
the varying cost structure of all the
capital components.

14. WACC Formula

15. Cost of Equity
(Ke)
The cost of equity is generally
derived using the Capital Asset
Pricing Model (CAPM) model that
lays out the cost of equity as
follows:
Ke = Rf + β (Rm-Rf)
Rf = Risk-free Rate. In economic
terms, it is the rate at which an
investor can earn returns without
taking any risk. The US treasury
bill rate can be considered as a
risk-free rate.
β = Beta factor. It is the
sensitivity index of an asset. It
indicates the magnitude of
movement in the underlying
asset when the market moves by
1.
Rm = Market Rate of Return.
Denotes the return earned by the
basket of stocks comprising the
market as a whole. The Rm may
also be industry-specific like the
real estate index or the utility
index. It can also be a collective
index such as the S&P 500.

16. Cost of Debt (Kd)
Kd = Interest (1-t)/Value of
Debt
Interest: This formula is very
intuitive. It occurs naturally
that the cost of debt will be
the interest one pays for it.
However, what is to be
understood is the (1-t)
factor.
Interest on borrowings is
basically tax-deductible.
This means that interest
leads to the prevention of
outflow of cash in the form
of taxes.
Therefore, the effective
cost of debt is less by the
proportion of the tax
component.

17. Cost of
Preference
Shares (Kp)
Kp = D0/P0
D0= Dividend (generally at a fixed rate); P0=
Price of preference share.
Like interest payments are a fixed obligation
for debt finance, dividends are a fixed
obligation for preference share capital.
Since dividends are paid out of after-tax
profits, they do not entail any tax shield
benefits.

24. Why is WACC important?
SERVES AS A BENCHMARK WACC GIVES THE
OVERALL COST OF
CAPITAL.
THIS INFORMATION IS
NECESSARY TO HAVE
WHEN ANALYZING
PROSPECTIVE PROJECTS
AND INVESTMENTS. WACC
IS THE MINIMUM RETURN
A BUSINESS SHOULD BE
ABLE TO GENERATE TO
BREAK EVEN.
IF A PROJECT’S ROI IS
LESS THAN THE WACC,
THE BUSINESS SHALL END
UP LOSING MONEY.
WACC IS, THEREFORE, AN
IMPORTANT BENCHMARK
AGAINST WHICH ALL
FUTURE INVESTMENTS
MUST BE COMPARED.

25. Why is WACC important?
Leverage Limits
Using a WACC calculation the management is instantly able to analyze the impact of leverage on its capital
structure.
The WACC combines the cost of both equity and debt to provide an aggregated number.
Using advanced models for WACC calculation the management can also arrive at the exact point at which the
cost of additional debt outweighs its benefits.
Therefore, the decisions regarding the quantum and cost of debt to be taken on can be made easily using a
simple WACC calculation.

26. Why is WACC
important?
Valuation Tool
WACC is also an effective
valuation tool for the
business of companies.
Analysts particularly
perform WACC calculations
to arrive at the combined
rate that is used to value
the firm.
WACC is a fundamental and
simple check to ensure
whether a company
satisfies the preliminary
parameters to qualify as
an investable business.
For example, a higher
proportion of debt
increases the risk factor
since the company is
exposed to liquidity risks.
This, in turn, caused the
investors to demand a
higher rate of return.
Therefore, the overall
WACC goes up leading to a
fall in valuation.

27. Why is WACC
important?
Application in DCF Calculation
WACC is also used as the discount rate
in NPV computation.
Since WACC is an all-inclusive rate it
constitutes the most suitable rate for
discounting cash flows that occur to
the entity as a whole.