BFD – Weighted Average Cost of Capital

By Ahmed Raza Mir & Taha Popatia

Weighted Average Cost of Capital

A) Determination of Market Value of Equity (E) and Ke using by Dividend

Valuation Model
 According to DVM, the market value of a share of a company is the Present value of all future cash
dividends expected from the company.
 It is discounted by using shareholders required rate of return i.e. Ke.

Constant Dividend Model

 Applicable to companies that are expected to pay constant cash dividend (Do) per annum.
 These companies have relatively stable earnings and very high (near 100%) pay-out ratio.

Po = Do / Ke

Where Po = Current market value of share

Do = latest dividend at time 0
Ke = Cost of Equity
Dividend Growth Model
Applicable to companies that are expected to pay cash dividends growing at a constant rate of ‘g’ % per
annum. The dividend growth model is applicable as long as growth rate is less than Ke or g is negative.
Po = Do (1 + g)
Ke – g

Estimation of Growth Rate

Past Dividend Patterns Earning retention model (Gordon’s
growth model)
1/n
Current Dividend g=bxr
-1
Dividend n years ago Where:
g = annual growth rate in dividends in
Where: perpetuity
b = proportion of earnings retained (for
n (periods of growth) = No. of Years – 1 reinvestment in the business)
r = rate of return that the company will
make on its investments
Note: If separate % of r is not given then,
assume r is equal to existing return on
equity.

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 BFD – Weighted Average Cost of Capital
By Ahmed Raza Mir & Taha Popatia
Others

 If dividends are Irregular (i.e. not constant as well as not growing at a constant rate) then, plot all estimated
future cash dividends and discount them individually by using Ke.
 Cum dividend is inclusive of dividend while Ex-dividend is exclusive of dividend.
 For dividend growth model ex dividend price is used.
 Ke will be post tax because dividend comes from post-tax profits therefore Ke always come post tax.
 Equity calculated via DVM is always Ex-dividend as these formulas calculate PV of all future dividends starting
from year 1. Accordingly, when Ke has to be estimated via these formulas, then ex-dividend value of Equity
has to be incorporated.
 As an alternative to DVM Ke can also be estimated via CAPM. Similarly Equity can also be calculated via other
share valuation techniques.

Pre & Post tax Calculation of Equity and Ke

 When Ke is calculated via DVM then it will be post-tax Ke.

 When Ke is calculated via CAPM then it will be post-tax Ke because it is shareholder’s pre-tax rate (we
use Rm & Rf both are pre-tax rates).

Remember: Shareholder’s/investor’s required return: Pre-tax = Company’s Ke: Post-tax

 For calculating WACC, we require company’s post-tax Ke. Accordingly, Ke determined either via DVM or
CAPM, it is directly taken without any further adjustment.
 If shareholder’s pre-tax required rate is given then, it will be taken directly as Company’s Ke (no
adjustment will be required)
 In DVM question, if Shareholder’s post-tax rate is given then, convert it into shareholder’s pre-tax rate by
using shareholder’s personal tax rate. After this adjustment now we can calculate Equity value by DVM or
WACC. For example, if shareholder’s 10% post-tax rate is given and shareholder’s personal tax rate is 30%
in this scenerio rather than using 10% as Ke in DVM formula or in WACC calculation, we will pass an
adjustment and convert this post-tax rate into pre-tax rate by simply dividing the post-tax rate by 1-tax
rate i.e. 10 ÷ (1-0.3) = 14.28% now 14.28% will be the Ke will & use in DVM formula as well as for WACC
calculation.
B) Determination of Market Value of Debt (D) and Kd
The market value of debt (D) is the PV of all future Cashflows of debt discounted via debt holders required rate of
return (Kd)

 FACE VALUE: it is the reference value which is used for calculation of coupon interest amount. Face value
is specified at the time of issuance of debt.
 COUPON RATE: it is the rate at which interest is actually paid by the borrower to the holder of the
security. Coupon rate is applied to face value to calculate coupon interest amount. This is also fixed /
determined at the time of issuance of debt.
 REDEMPTION VALUE: it is the amount at which the “Principal amount” of debt is to be settled / repaid
(except in case of “zero coupon bonds”). It may or may not be equal to the face value.
 MARKET VALUE OF DEBT: it is the amount at which the debt security can be easily purchased / sold in
the market today.

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 BFD – Weighted Average Cost of Capital
By Ahmed Raza Mir & Taha Popatia
 Arithmetically: where all the future cash flows of the debt are discounted using current market rate (Kd)
of the debt, we arrive at the debt’s Market Value denoted by D.
 Market Rate: it is the rate currently offered by securities of similar credit rating and similar tenure to
maturity.
 There is an inverse relationship between the market rate and market value of a fixed income security. A
decrease in the market rate will mean an increase in the market value of fixed income securities.

Irredeemable Debt

MV of Debt = I (1 – t)

Kd

Where I = Coupon interest amount

t = tax rate applicable to company

Kd = Cost of Debt after tax

 The after tax Kd of an irredeemable debt can also be calculated by,

Kd x (1 – t)
 In case of irredeemable preference shares the tax rate will be nil as unlike interest, payment to prefrence
shareholders is normally treated by tax authorities as distribution from profit and not an allowable
expense.

Redeemable Debt

 In order to Calculate MV of Debt, Future cashflows will be discounted via Kd.

 In order to calculate the Kd, Future cashflows will be plotted against MV of Debt and Kd will be calculated
by using IRR.
 See below for tax treatment.

Convertible Debt Securities

 In order to Calculate MV of debt or Kd, the process will be same as Redeemable debt.
 Since this debt is convertible therefore we need to determine first whether it will be converted or not. In
case the debt security is expected to be converted (when conversion proceed is higher than redemption
value/PV of further future cashflows till redemption), then conversion value will be incorporated in the
future cashflows.
1) Plot all future cashflows against MV including tax saving on
Pre & Post tax Calculation of Debt and Kd interest (where taxation is involved)
2) Calculate IRR of these Cashflows and the answer will be Post
 If MV of Debt is given and Kd is required tax Kd.
Assumption: Difference between MV & Redemption Value (Any
gain or loss on redemption) of a Security is not taxable

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 BFD – Weighted Average Cost of Capital
By Ahmed Raza Mir & Taha Popatia
 If Cost of Debt (Kd) is given and MV of Discount all future post-tax cashflows by using Kd and the sum of
Debt is required these discounted cashflows will be the MV of Debt.
Assumption: Difference between MV & Redemption Value (Any
gain or loss on redemption) of a Security is not taxable
 Instead of Kd if market rate is given and MV
of Debt is required

 This market rate is Pre-tax Kd for the company

 Discount all future pre-tax cashflows by using Pre-tax Kd and sum of these discounted
cashflows will be the MV of Debt.
Assumption: Difference between MV & Redemption Value (Any gain or loss on redemption) of a
Security is taxable

Remember: Lender’s required return: Pre-tax = Company’s cost of debt: Pre-tax

Post-tax Kd can be calculated as Post Tax Kd = Pre-tax Kd (1 – tax)

C) Calculation of Weighted Average Cost of Capital (WACC)

Weighted average cost of capital (WACC) is the average rate of return a company expects to compensate all its
different investors. It can be calculated as follows,

WACC = E x Ke + D x Kd

E+D

Where Ke = Cost of Equity (Shareholders required return)

Kd = Cost of Debt (Lenders required return)

E = Market value of Equity

D = Market value of Debt

In Case when there is more than one source of Debt finance, then WACC can be calculated as follows,

WACC = E x Ke + D1 x Kd1 + D2 x Kd2 + D3 x Kd3 + . . . . . .

E + D 1 + D2 + D3 + . . . . . .

Alternative Approach to Calculate WACC

 The following approach will only be used when the following assumptions are valid
1. Earnings are constant/stable WACC (Pre-tax) = PBIT
2. Debt is Irredeemable E +D
3. All earnings are paid out as dividends
WACC (Post-tax) = PBIT (1- tax)
E +D

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 BFD – Weighted Average Cost of Capital
By Ahmed Raza Mir & Taha Popatia

D) Determination of Discount Rate for Project Appraisal

1. If Business Risk & Financial risk (D/E ratio) remains same then,
 Existing WACC will be used as a discount rate. Because current WACC will becomes equal to
Marginal cost of capital and WACC before & after the project is same.
2. If Financial Risk changes and Business risk is constant
 Traditional Theory WACC would Change
 M&M Theory-without Taxation WACCu = WACCg therefore Existing WACC can be used
 M&M Theory-with Taxation WACCu > WACCg
 Risk Adjusted WACC or Adjusted Present Value (APV)
3. If Business risk / (Business and Financial risk) change
 Risk Adjusted WACC (because change in business risk will change Ke and therefore existing WACC is
not relevant) or APV

E) Risk Adjusted WACC & Adjusted Present Value (APV)

Change in Business / Financial Risk

APV
APV is an extension of M&M-with taxation. It is
Risk Adjusted WACC relatively superior technique as compared to NPV.
It gives the flexibility of analyzing the effects of
The existing WACC needs to be adjusted if the
using different sources of finance to fund a project.
investment has differing business risk and finance Steps
risk when compared with the existing company’s 1) Identify Beta Asset of the project
business. 2) Use Beta Asset to arrive at Keu via CAPM.
Steps Or
1) Find the appropriate equity Beta of industry in Alternatively, Keu can also be calculated via
which the company is planning to diversify M&M formula of WACCg or Keg.
3) Discount project cashflows Keu in order to
2) De-gear the Equity Beta i.e. convert it into
arrive at Base Case NPV
Asset Beta. 4) Add PV of all adjustments in base case NPV to
3) The ungeared Beta will now be adjusted for arrive at APV.
the financial risk (D/E ratio) of the project. Base Case NPV xxx
Now it will become Risk Adjusted Equity Beta. PV of adjustments
4) Use the above calculated Beta in order to PV of issue costs (xxx)
Calculate Risk Adjusted Ke via CAPM formula. PV of tax saving on issue cost xxx
PV of tax saving on interest of
5) Now use the above Ke and Put it into the
Debt (both utilized & spare debt
WACC formula in order to arrive at Risk capacity) xxx
Adjusted WACC and use this WACC to arrive at PV of subsidized debt xxx
NPV Adjusted Present Value (APV) xxx
Note: All adjustments will be discounted via
Pretax Kd / Rf

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 BFD – Weighted Average Cost of Capital
By Ahmed Raza Mir & Taha Popatia
Beta Asset

βa = βe E +βd D (1-t)
E+D (1-t) E+D (1-t)

a. Asset beta (βa) (also known as ungeared beta or project beta) is the beta of an ungeared company it
represents business risk only. Accordingly, all companies in same industry sharing same business risk should
have same asset beta.
b. Equity beta (βe) (also known as geared beta or company beta) is the beta of a geared company it represents
both business risk & financial risk. It denotes the risk of the shareholders.
c. Debt beta (βd) approximates to zero mostly. Therefore, the formula of beta asset simplifies to,

βa = βe E
E+D (1-t)

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