30. Calculation of Weighted Average Cost Of Capital from Financial Management Subject
Summary
TLDRIn this educational session, students are introduced to the concept of Weighted Average Cost of Capital (WACC), a crucial metric in finance used to determine a company's cost of capital. The lecture covers the cost of various funding sources including equity shares, preference shares, and debentures. The instructor explains how to calculate the cost of each, taking into account dividends, market prices, and growth rates. A step-by-step calculation of WACC is demonstrated using a company's capital structure as an example, highlighting the importance of understanding the weighted impact of different funding sources on a company's overall capital cost.
Takeaways
- 📚 The lecture introduces the concept of Weighted Average Cost of Capital (WACC), which is a key metric in finance used to determine the cost of a company's capital.
- 💼 Companies raise funds by issuing shares, debentures, and different types of equity, each with its own cost of capital.
- 🔢 The cost of capital is calculated for various sources like equity shares, preference shares, and debentures, considering factors like dividends, market price, and growth rate.
- 📈 The formula for calculating the cost of equity shares involves the dividend per share, market price, and growth rate of dividends.
- 📉 For preference shares, the cost is calculated as the dividend rate divided by the net proceeds from issuing the shares.
- 💹 The cost of debentures is determined by the interest rate, net proceeds from issuing the debentures, and the tax rate, with a focus on the after-tax cost.
- 📊 WACC is computed by taking a weighted average of the costs of different capital components, with weights based on the proportion of each in the capital structure.
- 💡 The lecture emphasizes the importance of understanding WACC for financial decision-making, as it represents the overall cost of capital to a company.
- 📑 The script provides a detailed example of calculating WACC, illustrating the process step-by-step with a hypothetical company's capital structure.
- 🎓 The lecture concludes with encouragement for students to practice similar problems to solidify their understanding of WACC calculations.
Q & A
What is the primary topic discussed in the video script?
-The primary topic discussed in the video script is the calculation of Weighted Average Cost of Capital (WACC).
What are the different components of capital a company might issue to raise funds?
-A company might issue shares, which include equity shares and preference shares, and debentures to raise funds.
What is the significance of calculating the cost of capital?
-Calculating the cost of capital is significant as it represents the cost of different sources of capital a company uses, which helps in making financial decisions and planning.
How is the cost of equity shares calculated when a growth rate is given?
-The cost of equity shares is calculated using the formula: (Dividend + (Dividend * Growth Rate)) / Market Price * 100.
What is the formula used to calculate the cost of preference shares?
-The cost of preference shares is calculated using the formula: Dividend / Net Proceeds * 100.
How is the cost of debentures calculated, and what role does the tax rate play in this calculation?
-The cost of debentures is calculated using the formula: (Interest / (1 - Tax Rate) / Net Proceeds) * 100. The tax rate is used to determine the after-tax cost of debt.
What is the weighted average cost of capital and why is it important?
-The weighted average cost of capital (WACC) is the average rate that a company expects to pay to finance its assets. It is important because it represents the overall cost of capital and is used as the discount rate in valuation models.
How are the weights for calculating WACC determined?
-The weights for calculating WACC are determined by dividing the market value of each component of capital by the total market value of all components.
What is the formula for calculating the weighted cost of each component of capital?
-The weighted cost of each component of capital is calculated by multiplying the weight of each component by its respective after-tax cost percentage.
What is the final step in calculating WACC after determining the weighted costs of each component?
-The final step in calculating WACC is to sum up the weighted costs of all components to get the overall WACC.
Why is it important to understand the capital structure of a company when calculating WACC?
-Understanding the capital structure of a company is important because it provides insight into the proportion of equity, preference shares, and debentures used, which directly influences the WACC calculation.
Outlines
📚 Introduction to Weighted Cost of Capital
The script introduces the concept of Weighted Cost of Capital (WACC) in the context of a lecture at Commerce and Management Academy. It explains that companies raise funds by issuing shares, which include equity shares and preference shares, as well as debentures. The lecture aims to teach the calculation of WACC, which is the average cost of all the different sources of capital a company uses. The script mentions that the company's capital structure is composed of different proportions of equity shares, preference shares, and debentures, each with different costs associated. The lecture will cover the calculation of the cost of each type of capital and then demonstrate how to calculate the WACC.
🔢 Calculating the Components of WACC
This paragraph delves into the specifics of calculating the cost of different types of capital that make up a company's WACC. It explains the formula for calculating the cost of equity capital, which involves the dividend rate, market price of shares, and growth rate. The script provides an example with given values for these variables and calculates the cost of equity capital to be 14.52%. It also covers the calculation of the cost of preference shares and debentures, emphasizing the importance of considering the tax rate when calculating the cost of debentures. The tax rate is applied to the interest paid on debentures to determine the after-tax cost, which is a key component in the WACC calculation.
📈 Demonstrating WACC Calculation with a Table
The script transitions to illustrating how to compute WACC using a table format. It outlines the columns needed for the table: sources of funds, amount, weights, after-tax cost percentage, and weighted cost. The weights are calculated by dividing the amount of each source of capital by the total capital. The after-tax cost percentage is determined from the calculations done in the previous paragraph. The weighted cost is then calculated by multiplying the weight of each source by its after-tax cost percentage. The sum of these weighted costs gives the WACC, which is presented as 10.78% in the example. This section provides a clear, step-by-step guide on how to compile the data and perform the calculations to arrive at the WACC.
🎓 Conclusion and Encouragement
The final paragraph wraps up the lecture by summarizing the process of calculating WACC and emphasizing its importance in financial decision-making. It encourages students to understand the calculations thoroughly, as questions related to WACC are commonly expected in exams. The script also prompts students to share the video and utilize available resources for study. The lecture concludes with well-wishes for the students' success in their studies.
Mindmap
Keywords
💡Weighted Cost of Capital (WACC)
💡Equity Shares
💡Debentures
💡Dividends
💡Market Price
💡Growth Rate
💡Tax Rate
💡Capital Structure
💡Retained Earnings
💡Cost of Debt
💡Cost of Preference Shares
Highlights
Introduction to Weighted Cost of Capital (WACC) and its importance in financial management.
Explanation of different capital sources like equity shares, preference shares, and debentures.
Understanding the cost of capital components: cost of equity, cost of preference shares, and cost of debentures.
Calculation method for the cost of equity shares using the dividend and market price.
Incorporating the growth rate in the calculation of the cost of equity shares.
The significance of tax rate in calculating the cost of debentures.
How to calculate the cost of preference shares using the dividend and net proceeds.
Detailed calculation of the cost of debentures considering the interest and tax rate.
Introduction to the concept of capital structure and its role in WACC.
Step-by-step calculation of WACC using the formula and given financial data.
Importance of understanding the weights of different capital components in WACC.
Calculation of the weighted cost of each capital component.
Final computation of WACC by aggregating the weighted costs.
Practical application of WACC in making investment decisions.
Emphasis on the importance of WACC in company's capital structure decisions.
Encouragement for students to focus and understand the WACC calculation process.
Summary of the key points covered in the lecture on WACC.
Transcripts
hello dear students welcome to day
because Commerce and management Academy
today we'll see weighted cost of capital
you know that whenever company wants
funds they'll be issuing shares shares
means differentiates and equity share
apart from that they'll be issuing
debentures also we have seen the
calculation of cost of
Capital cost of capital means cost of
preferentiates cost of equity shares
cost of debentures how do we calculate
that we have seen even cost of retained
earnings also four things we have seen
now all together
weighted average cap capital weighted
Capital cost of capital this we will see
today it means whenever company is
issuing shares debentures
and shares also different types of
shares so that structure capital
structure we say
companies accumulating through
preferences at 20 percent
and through equity share suppose say 40
percent
20 plus 40 comes to 60 percent and
through debentures 40 more percent means
2 4 4 in this ratio they are issuing
when they are issuing when they are
accumulating debentures or shares so
that weightage we wanted to see
weightage so all together how is the
weightage so for that we have to
calculate weighted average cost of
capital
so here we are going to calculate the
cost of debt cost of debentures cost of
references cost of equity shares these
three we are going to calculate why not
cost of retained earnings
are you getting a question yes cost of
written earnings it is in the company
itself only if they are going to
distribute the retained earnings to the
shareholders then they are going to
invest in the company with that
assumption we have calculated in fact
it's not exactly the cost for the
company that is why we are going to
calculate only the three things cost of
debt cost of preferentials cost of
equity shares all these things these
things will calculate then after that we
are going to calculate the average
weighted average cost of capital
through a problem I'll make you to
understand very easy just to focus for
5-10 minutes you'll understand okay
because already we have command over the
calculation or cost of debt cost of
equity Capital cost of differentiates
this we have good idea
and uh when the percentage is given
then very easy formula is also very easy
in the same passion will work out one
problem just focus now the if you see
the problem
the equity shares of a company are
quoted as 105 Equity shares cost of that
Equity shares is quoted 105 the company
plans to declare a dividend of 10 Rupees
per share
company wanted to issue 10 Rupees per
share
the growth rate of dividend is 5 percent
now what is this Equity shares
equitious cost is 105 okay and uh uh
they wanted to give dividend of 10
Rupees and growth rate is also given
five percent whenever growth rate is
given you know that how do we calculate
it
so D plus this is the formula D Plus
Market Price Plus growth rate into 100.
if growth rate is not given dividend by
market price
isn't it now here growth rate is given
I'll use another marker
growth rate is given our dividend is
five percent remember this point okay
I'm a clear up to here then after that
the tax rate is tax rate is 50 percent
tax tax rate means it is applicable when
we calculate cost of debt
debentures when we issue on the
debentures whatever interest we are
paying there we are going to get the tax
benefit you have an idea as we have done
so that is where tax rate 50 percent
means remember when we calculate the
cost of debt there we are going to use
tax rate 50 percent
calculate
weighted average cost of capital wacc
weighted average cost of capital okay
when the capital structure of the
company as on 31st March 2020
shows the following details when capital
structure is like this calculate
wacc weighted average cost of capital
what is the structure if you see equity
share capital
equity share Capital how much it is 9
lakh of one rupees
each share is one Rupee how many shares
are there nine lakh means cost is 9 lakh
rupees so this is equity share capital
10 person preferentiates preference
Shares are how much 10 percent
dividend will be given to the preference
shareholders what is the cost 6 lakh
rupees and ten percent debentures
debentures is five lakh rupees okay so
this this is the capital structure
they're asking us to calculate
wscc first what do we need to calculate
cost of equity Capital cost of
differentiates cost of debentures these
three we are going to calculate
very easy I've already done I just want
to explain
equity share Capital let us see first
cost of equity capital
Equity Capital whatever you say ke
simple formula because percentages are
given so K is equal to D by MP Plus
growth rate is given that is by G
otherwise d by MP d means dividend
dividend by market price
into 100 when growth rate is given
dividend by market Price Plus
growth
d by MP plus growth into 100.
now if you see dividend
dividend is how much Equity shares
declared 10 Rupees per share
so I have written here 10 Rupees per
share okay dividend by market price is
how much 105.
okay market price is 105 this is 100 and
510 plus growth rate growth rate is uh
five percent
five by hundred it comes to point zero
five five percent point zero for add
into hundred if you do the calculations
you will be getting 14.52 okay
ten by one not five means it is
0.095 plus
0.05 into 100 you'll be getting 14.52
percent cost of
cost of equity Capital when you are
issuing Equity Capital your cost is
14.52 okay now next to come to the cost
of preferential capital
cost of preferential Capital what is the
formula D by NP into 100 d means
dividend dividend by net proceeds into
hundred dividend is how much actually
they are saying cost of preferences ten
percent they are saying dividend is ten
percent out of 6
calculation of dividend I am showing you
here
so flag into ten percent six lakh into
ten percent comes to sixty thousand
sixty thousand is a dividend okay
dividend winner dividend buy net Process
net proceeds means total value of the
preferentiates six lakh sixty thousand
by six lakh into 100 it comes to ten
percent
ten percent is the cost of differentiate
now we'll go for the cost of debentures
cost of Dimensions cost of debentures
always remember here you are going to
take the tax
there we had dividend on the top
dividend by MP plus g into hundred now
here dividend by NP into 100 now no
dividend interest
because debentures
debentures we give the interest not
dividend so that is why formula is here
cost of dementia is KD
is equal to I into 1 by T 1 by Ty tax is
given
if not given simply we could we would
have taken I by NP into 100 I means
interest by NP net proceeds into hundred
so I into 1 by T by n n p into 100
already we have done
so I is interest interest how much 10
percent on this
here I have shown you
are you able to see
[Music]
there is a small shaking of the camera I
thought something is done so I'm showing
you the working notes Here
5 lakh into ten percent I like into ten
percent is fifty thousand fifty thousand
is the interest okay so interest fifty
thousand into one by T T tax rate is how
much
there is the tax rate
tax rate is 50 50 by 100 it comes to
0.50 okay 1 minus zero point five zero
divided by NP net proceeds total value
of the benches 5 lakh five lakh is
written into hundred
am I clear then after that what we have
done calculations
if you cut this three zeros four zeros 5
by 50 comes to point one zero okay point
one zero here one minus zero point five
zero is zero point five zero okay five
zero so this multiplication if you do
you are getting answer of five percent
up to here clear
what we have done
first we have calculated cost of this
one equity share Capital cost of equity
shared capital what's the formula
dividend by MP market Price Plus growth
rate plus G if growth rate was not given
simply we would have taken d by MP d by
MP plus g into hundred as per this you
got this then after that calculation of
preferentiates preferences very simple
dividend by NP into 100
dividend is uh 10 percent of this 60 000
NP is six lakh into hundred so you've
got 10 percent then after that
calculation of cost of debt cost of debt
is Formula is interest not dividend
interest into 1 minus t into C to 1
minus t by NP into 100
okay so interest rates here fifty
thousand five lakh ten percent is fifty
thousand into one minus t tax rate is 50
50 by 100 it comes to 0.50 divided by
total cost of the debentures are five
like net proceeds are 5 lakh into 100 so
you got five percent like we have
calculated
literally
cost of preference shares cost of equity
shares cost of debt we have calculated
now when we know these three values
cost of these three then we can show
through a table
wscc weighted average cost of capital so
now here computation of weighted average
cost of capital
what are the columns we are writing
first thing is that source of funds what
are the sources resources
right three sources I have written
equity share Capital first and
preferentiates debentures Equity shares
preferences debentures their value in
the second column number one First
Column source of funds okay second
column amount nine lakhs slack five lakh
nine six to five okay then after that
weights
weights we have to calculate how do we
calculate the weight for calculation of
weight this amount divided by the total
total if you see
965 this total is 20 lakh
wait wait when you wanted to calculate
this amount divided by 20 lakh
so I have written here second column
divided by 20 lakh second column is this
one 9 lakh divided by 20 lakh you will
be getting 0.45
did you remember weighted average also
we have done in statistics weighted
average weighted standard deviation also
we have done
the same passion nine lakh divided by
this you are getting weight
0.45 in the same way six lakh divided by
20 lakh into 100 so you are getting 0.30
5 lakh divided by 20 lakh 0.25 if you
total up everything it should be one
means hundred percent
if it is hundred percent one the weight
of equity share capital is 0.45
reference is 0.30 and the benches are
0.25 this is weight wait simply weight
we have calculated but we want aggregate
total isn't it weighted average cost of
capital reward so that is why the apart
from these columns we are going to
provide two more columns one one is
after tax cost percentage
after tax cost percentage means whatever
we have calculated like 14.5052
answers okay after tax cost percentage
cost percentage we have done a 14.52
here and this one is ten percent and
next five percent this we have done now
how do we calculate weighted cost third
column into this one
weights we have already calculated this
one and a calculated answers this one
three into four three into four comes to
this fifth column fifth column Okay so
0.45 into 14.52 6.53
0.30 into 10 3 like you got this
weighted cost you total up everything
you are getting 10.78
10.78 he is here weighted average cost
of capital I have written here therefore
weighted average cost of capital is
equal to 10.78
when what does it mean
it means when I am issuing
preferentiates Equity shares and
debentures
total all together
if I take the weights and all these
things my cost together all these things
when I issue my cost is 10.78
as per the weight this is the meaning
am I clear want to take screenshot here
it's very simple we know how to
calculate cost of dead cost of
differential cost of equity shares
simply we have calculated prepared table
table also row you know that source of
fund amount is same weight column we
have provided third one how do we
calculated by it how we have calculated
nine lakh divided by two lakh like this
you got the weight then after that after
tax cost percentage this amount
whatever we have calculated that cost
percentage we have written in third
column into fourth column conservated
cost
all total together is 10.78 is the
weighted average cost of capital simple
in exam most of the time you will expect
this kind of questions only because
total weight means there we are
calculating all everything is coming
under one umbrella that is why this
problem is important
will work out one more problem in the
next class hope you understood any dot
so please do share these videos and also
check out the playlist whatever is
available use it and study well have a
bright curry good luck
everybody
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