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    Cost of Capital - Formulae

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    Nikhil Chhabra
    This document discusses two methods for calculating the weighted average cost of capital (WACC). The first method uses a formula that weights the cost of debt, preferred stock, and equity based on their proportions of total capital. The second method calculates WACC based on the beta and capital structure of the company as a whole. It also provides formulas for un-levering beta to remove the effect of financial leverage, and re-levering beta to adjust for a target capital structure.

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    Cost of Capital - Formulae

    Uploaded by

    Nikhil Chhabra
    21 views4 pages
    This document discusses two methods for calculating the weighted average cost of capital (WACC). The first method uses a formula that weights the cost of debt, preferred stock, and equity based on their proportions of total capital. The second method calculates WACC based on the beta and capital structure of the company as a whole. It also provides formulas for un-levering beta to remove the effect of financial leverage, and re-levering beta to adjust for a target capital structure.

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    This document discusses two methods for calculating the weighted average cost of capital (WACC). The first method uses a formula that weights the cost of debt, preferred stock, and equity based on their proportions of total capital. The second method calculates WACC based on the beta and capital structure of the company as a whole. It also provides formulas for un-levering beta to remove the effect of financial leverage, and re-levering beta to adjust for a target capital structure.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    21 views4 pages

    Cost of Capital - Formulae

    Uploaded by

    Nikhil Chhabra
    This document discusses two methods for calculating the weighted average cost of capital (WACC). The first method uses a formula that weights the cost of debt, preferred stock, and equity based on their proportions of total capital. The second method calculates WACC based on the beta and capital structure of the company as a whole. It also provides formulas for un-levering beta to remove the effect of financial leverage, and re-levering beta to adjust for a target capital structure.

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    Dr. V.

    Rajesh Kumar
    VITTAM PRAVINA GURUSHALA
    www.drvrk.in
    WEIGHTED AVERAGE COST OF CAPITAL (WACC)

    METHOD ONE

    WACC (K) = KdWd + KpWp + KeWe

    Requirements:

    A. Source of Funds
    B. Specific Cost of Capital
    C. Weights

    A. Sources

    1. Debt
    2. Preference Shares
    3. Equity Shares
    4. Retained Earnings

    B. Specific Cost of Capital

    1. Cost of Debt (Kd) = R (1-T)

    Where,
    R = Expected Rate of Return
    T = Effective Tax Rate

    2. Cost of Preference (Kp) = R

    Where,
    R = Actual Rate of Dividend or Expected Rate of Dividend.

    3. Cost of Equity (Ke) = Rf + β(Rm-Rf)

    Where,
    Rf = Risk-free Rate of Return
    β = Beta of Equity Shares (Measure of Sensitivity)
    Rm = Market Rate of Return

    4. Cost of Retained Earnings (Kr) = Ke

    C. Weights

    First Preference Target Capital Structure Weights


    Second Preference Market Value Weights
    Last Preference
    Book Value Weights
    (only for academic purpose)

    1
    Dr. V. Rajesh Kumar
    VITTAM PRAVINA GURUSHALA
    www.drvrk.in
    METHOD TWO

    WACC (K) = Rf + βc(Rm-Rf)


    Where,
    Rf = Risk-free Rate of Return
    βc = Beta of the Company (also called Asset Beta)
    Rm = Market Rate of Return

    Calculation of βc

    When Company’s Capital Structure comprises of all sources of funding

    βc = βdWd + βpWp + βeWe

    When there are no Preference Shares in the Company’s Capital Structure

    βc = βdWd + βeWe

    When Company’s Capital Structure consists of only Equity Shares

    βc = βe (This is also called Unlevered Beta)

    2
    Dr. V. Rajesh Kumar
    VITTAM PRAVINA GURUSHALA
    www.drvrk.in
    UN-LEVERING AND RE-LEVERING BETA

    UN-LEVERING BETA

    βcomparable Company or Present capital structure = βdWd + βeWe

    If βd is assumed as Zero (i.e., if it assumed Debt is Risk-free),


    then-

    βcomparable Company or Present capital structure = βeWe


    (This is Unlevered Beta i.e., Beta after removing the effect of leverage)

    So, Unlevered Beta = βeWe


    or

    𝐄
    𝐔𝐧𝐥𝐞𝐯𝐞𝐫𝐞𝐝 𝐁𝐞𝐭𝐚 = 𝛃𝐞 𝐗 [ ]
    𝐄+𝐃
    or

    𝐄
    𝐔𝐧𝐥𝐞𝐯𝐞𝐫𝐞𝐝 𝐁𝐞𝐭𝐚 = 𝛃𝐞 𝐗 [ ]
    𝐄 + 𝐃(𝟏 − 𝐓)
    Where,
    βd = Beta of Debt
    Wd = Weight of Debt
    βe = Beta of Equity
    We = Weight of Equity
    T = Tax Rate

    3
    Dr. V. Rajesh Kumar
    VITTAM PRAVINA GURUSHALA
    www.drvrk.in
    UN-LEVERING AND RE-LEVERING BETA

    RE-LEVERING BETA

    𝑼𝒏𝒍𝒆𝒗𝒆𝒓𝒆𝒅 𝛃𝐞
    𝛃𝐞(𝐫𝐞𝐥𝐞𝐯𝐞𝐫𝐞𝐝) =
    𝑾𝒆 𝒐𝒇 𝑻𝒂𝒓𝒈𝒆𝒕 𝑭𝒊𝒓𝒎 𝒐𝒓 𝑵𝒆𝒘 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑺𝒕𝒓𝒖𝒄𝒕𝒖𝒓𝒆
    Or

    𝑼𝒏𝒍𝒆𝒗𝒆𝒓𝒆𝒅 𝛃𝐞
    𝛃𝐞(𝐫𝐞𝐥𝐞𝐯𝐞𝐫𝐞𝐝) =
    𝑬
    𝑬+𝑫
    Or

    𝑬+𝑫
    𝛃𝐞(𝐫𝐞𝐥𝐞𝐯𝐞𝐫𝐞𝐝) = 𝑼𝒏𝒍𝒆𝒗𝒆𝒓𝒆𝒅 𝛃𝐞 𝐗
    𝑬
    Or

    𝑫
    𝛃𝐞(𝐫𝐞𝐥𝐞𝐯𝐞𝐫𝐞𝐝) = 𝑼𝒏𝒍𝒆𝒗𝒆𝒓𝒆𝒅 𝛃𝐞 𝐗 [𝟏 + ]
    𝑬

    Or

    𝑫(𝟏 − 𝑻)
    𝛃𝐞(𝐫𝐞𝐥𝐞𝐯𝐞𝐫𝐞𝐝) = 𝑼𝒏𝒍𝒆𝒗𝒆𝒓𝒆𝒅 𝛃𝐞 𝐗 [𝟏 + ]
    𝑬

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