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Weighted Average Cost of Capital – Examining the Capital Structure of a Corporation

Weighted Average Cost of Capital is a calculation of the overall cost of capital used by a corporation and is an average representing the total return (in percent) that is expected of an organization on all its assets, debts and owner’s equity to maintain its current stock price & valuations. Weighted Average Cost of Capital weighs in all items that play a role in the corporation’s capital structure including common and preferred shares, bonds, and other long term debts.

In order to calculate the weighted average cost of capital, we must first examine the capital structure of the company we are analyzing. In terms of corporate finance, capital structure refers to how a corporation finances it assets and its business operations; either through the use of long term debt, common shares or preferred stock (also known as shareholder’s equity) or other hybrid securities. Weighted Average Cost of Capital becomes especially important when the capital structure of a firm involves both debt and equity financing. In this example, we will look at the three most common types of financing included in capital structure:

 i) Common shares equity ii) Preferred shares equity iii) Long term debt

Each of these components has a cost associated with it. Use of Weighted Average Cost of Capital comes usually at a time during merger and acquisition. Some financial analysts look at WACC objectively to examine the capital structure of the company and whether it is running at an optimal rate, or things could be tweaked for bettering the value provided to shareholders, as well as to optimize the value of the organization’s finances. The recommendations made by financial analysts after examining capital structures include either carrying more debt, less debt or issue more common/preferred shares, pay off debt and issue more equity, or trade debts with different interest rates.

Steps for Calculating Weighted Average Cost of Capital

There are three steps for calculating the WACC of an organization.

 1) Determine the proportionate weighting of each source of capital financing based on their market value. 2) Calculate the after-tax rate of return or cost of each source. 3) Calculate the weighted average cost of all sources

The formula for WACC is:

 WACC = (Ke x We) + (Kp x Wp) + Kd/pt [1 – t] x Wd) Ke =Cost of capital -common equity We =Percent of common equity in the capital structure, at market value Kp = Cost of preferred equity (shares) Wp =Percentage of preferred equity in the capital structure (at market value) Kd/pt =Cost of debt (pre-tax) T = Tax rate Wd=Percentage of debt in the capital structure (at market value)

Example of Weighted Average Cost of Capital in Tabular format

 Value Dollar Amount Percent of Total Value Assumed Cost of Capital (% Return) i) Book Value a) Debt 300 bonds at par, or \$1000/bond \$300,000.00 9.60% 7.00% b) Preferred Stock 5000 shares @ \$50 par value \$25,000.00 0.80% 12.00% c) Common Stock 10,0000 shares outstanding @ \$28 par value \$2,800,000.00 89.60% 9.00% Total Book Value of Capital \$3,125,000.00 100% ii) Market Value a) Debt 480 bonds at par, or \$1000/bond \$480,000.00 9.01% 7.00% b) Preferred Stock 10,000 shares @ \$65 par value \$650,000.00 12.20% 12.00% c) Common Stock 120,000 shares outstanding @ \$35 par value \$4,200,000.00 78.80% 9.00% Total market value of capital \$5,330,000.00 100% Calculating Weighted Average Cost of Capital (WACC) based on Market Values Sources of Financing Cost of Capital (%) Market Value Weight Cost of Capital x Market Value Weight (%) a) Debt (1 - t) = 1 - 0.4 4.20% 9.01% 0.38% 480 bonds at par, or \$1000/bond b) Preferred Stock 12.00% 12.20% 1.46% 10,000 shares @ \$65 par value c) Common Stock 9.00% 78.80% 7.09% 120,000 shares outstanding @ \$35 par value 100% Weighted Average Cost of Capital (%) 8.93%

Below is graphical representation of the market value of the weighted average cost of capital calculations. It shows how the capital structure is divided in to 3 parts consisting of \$480,000 debt (9% in blue), \$650,000 of preferred stock (12% in pink) and \$4,200,000 of common stock (79% in green).