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Understanding Weighted Average Cost of Capital (WACC) Calculations

The cost of capital of a company is calculated at a given time and reflects the average cost of capital in the company in the long term.

Capital structure basically consists of two main sources, namely debt (in this case it is long-term debt) and equity.

Equity is further divided into three parts, namely preferred stock, common stock and retained earnings

For more details, you can see the following image:

Company's Long-Term Capital Source
Company’s Long-Term Capital Source

Each Company will strive to maintain an optimal proportion of debt and equity in a certain range called the target capital structure.

Weighted Average Cost of Capital (WACC) is the weighted average of a Company’s capital costs.

if it is known, for example, the capital structure of company X consists of 40% debt and 60% equity. The cost of debt is 7%, and the cost of equity is 12%.

So the WACC of Company X is: (0.4 x 7 %) + (0.6 x 12 %) = 2.8 % + 7.2 % = 10 %

WACC is very important in making investment decisions in the Company. Every investment project in a company must provide a greater return (IRR) than the company’s WACC.

In addition, WACC can be used as a discount rate of a company’s future cash flows. The net present value (NPV) of the company’s potential future cash flows can be compared to the stock market price to assess its valuation.

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For more details, here’s the formula for Weighted Average Cost of Capital (WACC) 

wacc_formula
Weighted Average Cost of Capital (WACC) Formula

Now, let’s discuss one by one the components of the WACC. 

To make it easier to understand, on each component of the WACC I included a case example of an imaginer company (let’s say “danieel.id Bersaudara“).

1. Cost of Debt

Debt (in this case especially long-term debt) of a company can be in the form of debt to the bank, or in the form of debentures sold to the capital market (corporate bond).

Cost of Debt is the cost (in this case interest) that must be borne by the company as a consequence of debt.

In the Income Statement structure, the cost of debt (interest expense) is located before net profit before taxes, this means that this cost component is tax deductible.

To get the after-tax cost of debt, the value of before-tax cost of debt needs to be multiplied by 1 reduced tax rate (corporate income tax).

Here’s the formula for after-tax cost of debt:

after-tax cost of debt formula

Because of its nature as a tax deduction, in the capital structure of a Company, long-term debt is the cheapest source of financing for a company, compared to other sources of capital such as preferred stock or common stock equity.

But of course there is a certain limit for a company to optimize its financial leverage (the use of debt to add assets), among others, in terms of the company’s Debt Ratios.

Quoting Aswath Damodaran, to calculate or estimate the cost of debt of a company, can be done in the following way:

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  • If the Company has a traded outstanding straight bond, then the cost of debt can be calculated from the yield to maturity (YTM) of the bond.
  • If the Company has a credit-rating from a credit rating agency, then the cost of debt can be calculated from the default spread of the rating against Risk Free (a risk-free investment, usually using the reference rate of government bonds).  
  • What about a company that doesn’t have a credit rating ? :
    • If the company has just made a long-term loan to a bank, then the cost of debt can be estimated from the interest rate of the loan, or
    • The cost of debt can be calculated using the approach of a synthetic rating, obtained from the company’s debt ratios.

In this article I give an example of the cost of debt calculation method, namely the yield to maturity (YTM) method.

Yield to maturity (YTM) is the total yield of a bond consisting of interest and capital gains earned by an investor when holding the bond until maturity.

In the case of corporate bond, reviewed from the side of the Company issuing the bond, this means the total cost incurred related to the bond, which consists of interest costs and floatation costs.

The company “danieel.id Bersaudara” issued a total corporate bond worth Rp 500 billion, minimum purchase requirement (par value) of Rp 100 million with a tenor of 10 years and a coupon of 9.5%.Flotation cost 3 %. Bond sold at par value (100%). 

What is the YTM value of the Bond issuance?

First we calculate the Net Proceeds (net value received by the company) from the bond.

flotation cost of 3% equals 3% x Rp 100,000,000 = Rp 3,000,000

Thus the Net Proceeds are 100,000,000 – 3,000,000 = Rp 97,000,000

Then we input the known data in the Microsoft Excel calculation as shown below:

cost to debt ytm calculation
Calculation of yield to maturity for cost of debt using Microsoft Excel

As we can see in the calculation above, the yield to maturity (YTM) that becomes the before-tax cost of debt in this case is 9.99%.

To get the after-tax cost of debt we need to multiply it by 1 minus tax rate as described earlier.

The assumption of corporate income tax is 25%, then the after-tax cost of debt company “danieel.id Bersaudara” is: 9.99 % x (1-0.25) = 7.49 %

For more detailed discussion and examples of cost of debt calculation with other methods, please read my article that specifically discusses the cost of debt:

How to Calculate a Company’s Cost of Debt

In the article I describe in detail various methods to calculate the cost of debt, an explanation of corporate bonds, the relationship between the company’s credit rating and the cost of debt, as well as an explanation of synthetic rating, of course accompanied by examples of detailed calculation examples to make it easier to understand.

 

2. Cost of Preferred Stock

Preferred stock is a type of stock that gives certain priority to the owner, among others, entitled to precedence in terms of dividend payments and entitled to priority payment if the company is liquidated. 

Usually these preferred stocks get fixed interest, similar to bonds.

Another difference with common stock, in general, preferred stock owners do not have voting rights at the GMS. (General Meeting of Shareholders)

Cost of Preferred Stock is calculated by dividing the annual dividend value of the preferred stock by net proceeds (the net value obtained by the company from the sale of the preferred stock).

In the issuance of a security, be it bond or stock, known as flotation costs, or or issuance costs consisting of underwriting costs (fees for underwriters) and administrative costs.

Net Proceeds from preferred stock are obtained by reducing the selling price of the preferred stock by its flotation cost.

Here is the formula for calculating the cost of preferred stock: 

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cost of preferred stock formula

Example:

The company “danieel.id Bersaudara” sells Preferred Stock with an annual dividend of 10% at a price of Rp 3,000 per share. Flotation Cost of the sale of preferred shares is 2% (Rp 60 per share).

What is the Cost of Preferred Stock of the “danieel.id Bersaudara” company?

First we calculate net proceeds (net value received by the Company) from the sale of preferred stock = Rp 3,000 – Rp 60 = Rp 2,940 per share

Then we calculate the value of the annual dividend that needs to be paid by the company = 10 % x Rp 3,000 = Rp 300 per share

So according to the formula already mentioned above, the company’s Cost of Preferred Stock “danieel.id Bersaudara” = Rp 300 / Rp 2,940 = 10.2%

We see here the cost of preferred stock of the company “danieel.id Brothers” (10.2%) is higher than the cost of debt (7.49%).

This is among others because the cost of debt is a tax deductible. Another cause is preferred stock is more risky than long-term debt.

If the company is liquidated, the first priority to get a pay-out is the creditor/lender who provides long-term debt, then the preferred stock shareholder, and lastly the common stock shareholder.  

Okay, let’s go to page 2, we’ll talk about The Cost of Common Stock Equity

This post is also available in: Indonesian

Daniel
Danielhttps://danieel.id
Lahir di Palembang pada bulan November 1981, saya menyelesaikan S1 di Jurusan Teknik Kimia Universitas Sriwijaya, dan S2 Master of Business Administration (MBA) di Sekolah Bisnis Management Institut Teknologi Bandung (SBM-ITB). Bekerja di salah satu BUMN dan tinggal di daerah Jakarta Selatan.

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