30. Calculation of Weighted Average Cost Of Capital from Financial Management Subject

Summary

In 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

00:00

📚 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.

05:01

🔢 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.

10:04

📈 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.

15:06

🎓 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.

Keywords

💡Weighted Cost of Capital (WACC)

WACC is a financial metric that represents the average cost of capital for a company, taking into account the proportionate weights of its different sources of capital, such as equity, debt, and preferred shares. In the video, the concept is central to understanding how a company's overall cost of capital is calculated. The script provides a detailed example of calculating WACC by considering the cost of equity, cost of preferred shares, and cost of debt, each weighted according to its proportion in the company's capital structure.

💡Equity Shares

Equity shares refer to the ownership stakes in a company that are bought and sold on stock exchanges. They represent the residual claim on a company's assets after all its liabilities have been paid. In the script, the cost of equity shares is calculated using a formula that includes the dividend per share, market price of the share, and the growth rate of dividends, which is a fundamental aspect of determining the WACC.

💡Debentures

Debentures are a type of debt security issued by a company that does not have a specified collateral behind it. They are essentially loans to the company, and the interest paid on them is tax-deductible. In the video, the cost of debentures is calculated by considering the interest rate, net proceeds from the debenture issue, and the tax rate, which is a key component in the WACC calculation.

💡Dividends

Dividends are the payments made by a corporation to its shareholders, usually derived from the company's earnings. They are a crucial element in calculating the cost of equity, as the script explains using the formula D/MP + g, where D stands for dividends, MP for market price, and g for growth rate. Dividends are a key factor in determining the return on investment for shareholders.

💡Market Price

The market price of a security, such as a share of stock, is the current price at which it can be bought or sold in the market. In the context of the video, the market price of equity shares is used in conjunction with dividends to calculate the cost of equity, which is an essential step in determining WACC.

💡Growth Rate

The growth rate in the context of the video refers to the expected increase in dividends over time. It is used in the calculation of the cost of equity shares, as explained in the script with the formula D/MP + g, where g represents the growth rate. The growth rate is an important factor as it reflects the company's potential for future earnings and, consequently, the value of its shares.

💡Tax Rate

The tax rate is the percentage of tax paid on a specific income or transaction. In the video, the tax rate is used in the calculation of the cost of debentures, where the interest paid on the debentures is tax-deductible. The script explains that the after-tax cost of debt is calculated using the formula I/(1 - T), where I is the interest and T is the tax rate, which is a critical aspect of the WACC calculation.

💡Capital Structure

Capital structure refers to the composition of a company's funding sources, including equity, debt, and other components. The script discusses how the capital structure is used to determine the weights for each component in the WACC calculation. Understanding a company's capital structure is vital for investors and managers as it influences the company's cost of capital and financial risk.

💡Retained Earnings

Retained earnings are the accumulated net income of a company that has not been distributed as dividends to shareholders. In the video, retained earnings are mentioned in the context of not being a direct cost to the company unless they are distributed to shareholders. Retained earnings are an important source of internal financing for a company and can influence its capital structure.

💡Cost of Debt

The cost of debt is the return that a company must pay to its creditors. In the video, the cost of debt is calculated using the interest rate on the debentures, the tax rate, and the net proceeds from the debenture issue. Understanding the cost of debt is essential for financial managers as it helps in evaluating the company's overall cost of capital and making financing decisions.

💡Cost of Preference Shares

The cost of preference shares is the return that a company must pay to its preference shareholders. In the script, this cost is calculated by dividing the dividend by the net proceeds from the issue of preference shares. Preference shares are a type of equity that typically pays a fixed dividend and has priority over common shares in the payment of dividends and liquidation.

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