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Weighted Average Cost of Capital (Cost of Capital (There is a hypothetical…
Weighted Average Cost of Capital
Cost of Capital
All providers of finance require returns
The required return will reflect the risk of the investment and the returns of alternatives
Companies need information about the cost of different sources of finance in order to find the overall cost of finance and make investment and financing decisions
Perhaps an 'optimum' capital structure exists, which a firm can seek to achieve
The cost of capital is the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security
This rate is determined by the returns offered on alternative securities with the same risk - the opportunity cost
There is a hypothetical linear relationship between risk and return
Greater risk = Greater return
What is the minimum rate of return that will satisfy shareholders?
Rate of Return
Is the return appropriate to the risk?
Shareholders Perspective
What is the cost of inducing purchase and retention?
Firm's perspective
Cost of Share Capital
Investors in shares and debt require a return which provides for two elements:
A return equal to the risk free rate
An investment must at least match the risk free return
A risk premium
An investment must compensate for excess risk
Calculating the risk premium
Step 1
Estimate the average risk premium for shares
Step 2
Adjust the average premium to suit the risk on a particular share
Capital Asset Pricing Model
The CAPM assumes a linear relationship between risk and return that can be used to find cost of equity
The CAPM suggests that the cost of equity is proportional to the systematic risk, Beta, of a firm
Beta is a measurement of systematic risk, the variability of share price of a firm relative to the market
Different firms have different beta i.e. different levels of risk
The higher the Beta, then higher the premium or compensation for the risk
The cost of equity can be calculated using the CAPM
Step 1
Calculate the cost of each finance source
Step 2
Calculate market value and weighting of each source of finance (market value reflects current opportunity cost)
Step 3
Multiply each cost by its relative proportion then sum
The weighted average cost of capital is calculated by weighting the cost of debt and equity in proportion to their contribution to the total capital of the firm
To find the average cost of capital, we weight individual costs of capital by their proportions in the firm's capital structure
E = Value of Equity
D = Value of Debt
Various Sources of Finance
Cost of irredeemable debt = Kid
Cost of redeemable debt = Krd
Cost of Equity = Ke
Cost of bank loans = Kbl
Cost of preference shares = Kp
The WACC is a combined average opportunity cost for the various sources of finance
WACC links the financing decision with the investment decision so it is a key "threshold concept" in understanding finance
Restrictions
Business risk of investment project is similar to business risk of existing operations
Incremental finance is raised in proportions that preserve existing capital structure
Required return of existing finance sources is not affected by new investment project