Owolabi, Folashade

What is WACC?
It is the overall cost of obtaining capital by an

organization.
For a company to commence operations or
start a new project, it needs to raise funds.
These funds can be from various sources,
hence the need to aggregate the cost of all
funds in order to know the total cost of all
investment funds to an organization.
The cost of capital is made up of the
individual components of the capital structure.

TYPES OF CAPITAL
Equity/ share capital
Preference share capital
Debt capital

EQUITY CAPITAL
This refers to capital raised from

shareholders.
Equity capital is usually referred to as Ke.
There are two METHODS of calculating K e.

They are
Dividend growth model
Capital Asset pricing model (CAPM)

DIVIDEND GROWTH
MODEL
This is calculated as
D0 (1 + g) + g
P0
Where
D0 is dividend
g is the growth rate
P0 is the current share price

ASSUMPTIONS OF DIVIDEND
GROWTH MODEL
Dividend per share grows at a constant rate.
The expected dividend growth rate should be

less than the cost of equity.

This model is less widely used compared to
CAPM.
State the implications of this assumptions.

CAPM
This is calculated as
Ke = Rf + (Rm Rf)
Where
Ke is the cost of equity
Rf is the risk free rate
is the measurement of risk factor
(Rm Rf) is the equity risk premium

ASSUMPTIONS OF CAPM
Shares are publicly traded.

NOTE
All variables in the CAPM are market
determined
However, the challenge with the risk factor
(beta) is that it may not remain stable with
time.

QUESTION
When do you use CAPM or dividend growth

model?

PREFERENCE SHARE
CAPITAL
This is an equity type of capital but fixed amount
is paid as return to the investor every year. This
is the similarity between preference share capital
and debt.
It is calculated as
Kp = D/P0
Where
Kp is cost of preference share
D is dividend per share
P0 is share price

DEBT CAPITAL
Debt capital is denoted as Kd. There are three

types of debts.
Bank loan: it is calculated as
Kd = Coupon rate (1-t)
Irredeemable bond (loan notes)

Kd = I (1 t)/P0, I is interest p.a, t is tax rate, P 0

is market value of bond
Redeemable bonds (Loan note)
This is calculated using IRR of cash flows

CAPITAL STRUCTURE
Capital structure includes:
Long term debt
Preferred stock
Equity
Common stock
Retained Earnings

Determinants of choice of
capital
The decision to use any of these securities
depend on
Availability of access
Objective of the company
Cost of acquiring each of them.

Three basic steps in calculating WACC

include:
Determining the cost of each type of capital
Calculating the market values of each type of
capital
Obtaining the weight of the costs according to
proportions based on market values.
NOTE that WACC is based on market values

CALCULATING WACC

ILLUSTRATION 1
Security

Amount

Costs

Long

25, 000

0.30

10,000

0.10

40, 000

0.15

80, 000

0.45

term

debt
Preferred
stock
Retain
Earnings

Common
stock

155, 000

Solution
Security

Amount

Proportion

Costs

Product

(weight)
Long term debt

25, 000

0.1613

0.30

0.0484

Preferred stock

10,000

0.0645

0.10

0.0065

Retain Earnings

40, 000

0.2580

0.15

0.0387

Common stock

80, 000

0.45

0.2322

155, 000

WACC

0.5161
1.0000

0.3258
32.58%

ILLUSTRATION 2
Glory Plc is commencing a new business and

therefore needs to raise more capital. The

company uses weighted average cost of
capital (WACC) in appraising its new projects.
You are required to calculate the WACC of
Glory Plc using the following details:
The company has 20 million existing shares
with a market value of N3 each. The risk
factor of each share is 0.9.

ILLUSTRATION 2 CONTD
The company has a bank loan of N16m with a

prevailing rate of 7% per annum. It also issued

N10m of 10% redeemable bonds with current
trading price of N110 per N100 nominal value.
The bonds are redeemable at par in four
years time.
The corporate tax rate is 20%, risk free rate is
4% and the equity risk premium is 8%.

The use of WACC

New investments are financed by either equity or debts.

For example, retained earnings, share issues and loan

facility.
Therefore it is used as the cost of capital (discount rate) in
evaluating a new investment/project in an organization.

Reason for using WACC

contd
An organisations WACC shows its capital
structure on a long term basis

ASSUMPTIONS OF WACC
The new project has the same risk as the

organizations existing activities

The capital structure of an organization is
stable over time.

LIMITATIONS OF WACC
A new investment might have its own peculiar business

risk which can cause a fluctuation in the income required

by the financiers.
In the course of raising funds, a floating rate debt capital
might be raised which implies that the interest rate will be
subject to variations in market conditions. Hence,
including such costs into the calculation of WACC
becomes complicated.

THANK YOU