WEIGHTED AVERAGE COST OF CAPITAL(WACC)

Prepared by:Ali Mashood 152403Sami ullah 152402Alzumar Tufail152401

AT THE END OF THIS PRESENTATION:

YOU WILL HAVE THE BASIC UNDERSTANDING WITH WACC CONCEPTS.WE WILL DISCUSS

DEFINITION EXPLANATION FORMULA CASE STUDY QUESTIONS.

IMPORTANCE OF WACC TO STUDENTS

ACCOUNTING & FINANCE STUDENTSPROJECT MANAGEMENTMARKETINGACCA , C.A & CIMAOTHER ACCOUNTING CERTIFICATIONS

What is 'Weighted Average Cost Of Capital – WACC?

MODES OF FINANCING:

INTREST INTREST OROR PROFIT..??? PROFIT..???

DEIFNITION :The weighted average cost of capital (WACC)

is the rate that a company is expected to pay on average to all its security holders to

finance its assets.

The WACC is commonly referred to as the firm's cost of capital.

USERS OF WACCA DECISION MAKERS

(CEOs, DIRECTORS & MANAGERS) . In order to make decisions like MERGERS, JOINT VENTURES,

EXPANSION, COMPANY’S FINANCIAL STRUCTURE etc. DEBTORS

(BANKS & FINANCIAL INSTITUTIONS). Check that weather company is in a position to pay back the PRINCIPAL

AMOUNT and INTREST as well. INVESTORS

(SHARE HOLDERS). Check that weather company is in a position to pay REQUIRED RATE

OF INTREST. OTHERS

(FINANCIAL ANALYST, ECONOMIST , JOURNALS & Govt. REGULATORY AUTHORITIES).

Check that weather company is in a position to pay back the PRINCIPAL AMOUNT and INTREST as well.

VERY SIMPLE WACC FORMULA IS...

WACC = (% E * Re) + {(% D * Rd) * (1 – Tc)}= (E/V * Re) + {(D/V * Rd) * (1 – Tc)}

Where: Re = Cost of Equity Rd = Cost of Debt E = Market value of the firm's equity D = Market value of the firm's debt V = E + D = Total market value of the firm’s

financing (Equity & Debt)

E/V = Percentage of financing that is equity D/V = Percentage of financing that is debt Tc = Corporate tax rate

CASE STUDY # 1

A firm's financial data shows the following:

Equity = $8,000Debt = $2,000Re = 12.5%Rd = 6%Tax rate = 30%

SOLUTION...

To find WACC, enter the values into the equation and solve:WACC = [(8,000/10,000 * 0.125)] + [(2,000/10,000 * 0.06 * (1 - 0.3)]

WACC= 0.1 + .0084 = 0.1084 or 10.84%

THE WACC FOR THIS FIRM THEN IS 10.84%.

CASE STUDY # 2 Suppose that lenders requires a 10% return on the money they have lent

to a firm, and suppose that shareholders require a minimum of a 20% return on their investments in order to retain their holdings in the firm. If the only money in the pool was $50 in debt holders’ contributions and $50 in shareholders’ investments, and the company invested $100 in a project, to meet the lenders’ and shareholders’ return expectations.

Calculate how much RETURNS the project would need to generate to satisfy its debtors & creditors.?

SOLUTION...On average, then, projects funded from the company’s

pool of money will have to return 15% to satisfy debt and equity holders. This 15% is the WACC.

The project would need to generate returns of $5 each year for the lenders and $10 a year for the company’s shareholders.

HOW TO CALCULATE COST OF EQUITY..?

ONE MORE FORMULA Capital Asset Pricing Model (CAPM).Cost of Equity = Rf + b * (Rm – Rf)

Rf = Risk Free Rate of Return Rm = Market Rate of Return b = Beta

The Rate of Return (Market Return) refers to the returns generated by the market in which the company's stock is traded. If company CBW trades on the NASDAQ and it have a return rate of 12%, this is the rate used in the CAPM formula.

The Risk-Free Rate is generally defined as the rate of return on short-term U.S. Treasury bills or T-bills, because the value of this type of security is extremely stable and return is backed by the U.S. government.

The Beta of the stock refers to the risk level of the individual security relative to the wider marker. A higher beta indicates a more volatile stock and a lower beta reflects greater stability.

Cost of Equity = Rf + b * (Rm – Rf)Cost of Equity = Rf + b * (Rm – Rf)

How to Find Beta

Beta Coefficient = COV(rs ,rm) σ2m

rs = Stock Return r rm = Market Return σ2m = Market Variance

Case Study # 1 If the risk-free rate of a Treasury bill is 4%, and the return of

the stock market has averaged about 12%, what is the required return of a stock that has a beta of 1.4?

By using the CAPM formula, shown above, we find that:Cost of Equity =Rf + b * (Rm – Rf)

Required Return = 4% + [1.4 × (12% - 4%)] = 4% + 1.4 × 8% = 4% + 11.2%

=15.2%

CONCLUSION

Investors differ in their willingness to accept risk for a greater return. But if investors are willing to invest in the stock market, then they are willing to assume some risk. What the capital asset pricing model provides is a consistent means to price risk premiums. If you are willing to accept higher risks to get higher returns, then it makes sense to demand a higher return for a higher risk; otherwise, why take the higher risk. By comparing the beta of a stock and its historical return with that of the general market, you can determine whether the return of a stock is worth its risk.