Weighted average cost of capital
1 Difference between required return and the cost of CAPITAL
·Perspective
·The required return is from the investors' perspective: what is the return required to compensate for the perceived level of risk.
·The cost of capital is from the company's perspective: What is the minimum return the company must produce to compensate investors?
·Therefore, the required return on equity is equal to the cost of equity.
·Corporate tax
·However the required return on debt is not equal to the cost of debt, because companies receive tax relief on interest payments.
2 The weighted average cost of capital – WACC
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·Perspective
·The required return is from the investors' perspective: what is the return required to compensate for the perceived level of risk.
·The cost of capital is from the company's perspective: What is the minimum return the company must produce to compensate investors?
·Therefore, the required return on equity is equal to the cost of equity.
·Corporate tax
·However the required return on debt is not equal to the cost of debt, because companies receive tax relief on interest payments.
| Return of investors | Cost to the company | Market value | |
| Equity | Ke | Ke | The present value of future cash flows discounted at the investor’s required return. |
| Debt | Kd | Kd x （1-t） |
2 The weighted average cost of capital – WACC
General formula for the WACC:
WACC=Ke*E/（E+D）+ Kd*（1-t）*D/（E+D）
Where Ke=cost of equity
Kd=cost of debt
E=market value of equity
D=market value of debt
t=rate of company tax
Steps:
①Calculate market value of Debt and Equity, D+E
②Calculate Ke
③Calculate Kdat
④Calculate WACC
Back：Factors to consider when choosing different types of finance
Next：Geared and ungeared betas
