Explain what weighted average cost of capital (WACC) is, and explain its constit

Question

Explain what weighted average cost of capital (WACC) is, and explain its constituents. Provide verbal and symbolic explanations. Add a fictitious example for better clarification Explain in your example how expected rate of return is evaluated, is it based on an unleveraged beta or leveraged beta. Also, include your assumptions on risk free rate of return and market portfolio rate of return in evaluating expected rate of return.

Please provide me an example for the requirement mentioned above. Please treat the bolded words important. looking for an example to be given by anyone which has all that solved and stated.

Explanation / Answer

WACC is the weighted average of different cost that company bears to avial the fund. Capital structure of the company consist of equity capital , preference capital and loan fund, Each component have differet cost. Cost of equity is refered to as Ke , cost of debt is refered to as Kd and cost of preferece share is refered to as Kp
Let us understand how these cost are measured
Cost of equity = Rf+b(Rm-Rf)
where Rf = risk free rate of return
Rm = market return
b = beta
Cost of debt = Interest(1-tax)
Cost of preference share = Dividend rate

Let us understand how to calculate WACC using an example
For eg: Ke= 10%, Kd= 5% , Kp =15%
Capital structure
Equity share capital = 500$, Pref share capital = 200$, Debt = 1000$
WACC =

Thus WACC = 12.4%. It means company has to pay cost of 12.4% for sourcing the fund.

Thus one can say if company can earn more than WACC from a project than only it should acept the project

WACC actually consider both levered and unleavered beta. However while evaluating expected rate of return , unleavered beta is used as it help to clarify the distiction that Equity is less risky than the debt

Risk free rate is the rate of return offered by government securities and is generally assumed to be constant

Particulars Amount Weight K Weight*K Equity 500 0.294 10% 0.029 Pref 200 0.118 5% 0.006 Debt 1000 0.588 15% 0.088 1700 0.124

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