www.edupristine.

com

Calculating WACC

Imp

Cost of Capital

Cost of Capital the rate of return that the suppliers of capital, bondholders and owners, require as a
compensation for their contribution of capital.
It can also be viewed as the opportunity cist of funds for the suppliers of capital.
Component Cost of Capital: A source of the companys funding

Marginal Cost: What it would cost to raise additional funds for the potential investment project.

Neev Knowledge Management Pristine

www.edupristine.com

Imp

WACC

Weighted average cost of capital (WACC) or Marginal Cost of Capital (MCC)

Components of Capital

Cost

Weight age

Debt

Kd

Wd

Preferred Stock

Kps

W ps

Equity Stock

Ke

We

WACC = Wd *[(Kd(1-t)] + Wps*Kps + Wce*Kce

Note: For debt, after tax cost of debt is taken

Neev Knowledge Management Pristine

www.edupristine.com

Imp

Cost of equity capital (Ke)

Neev Knowledge Management Pristine

www.edupristine.com

Imp

Cost of equity capital (Ke)

Neev Knowledge Management Pristine

www.edupristine.com

Beta and Cost of Capital for a Project

When using CAPM to estimate the cost of equity, Beta must be estimated.
A method is to use regression of the stocks returns (Ri) against market returns (Rm)
Ri = a + b(Rm)
a is the estimated intercept
B is the estimated slope or Beta

Beta Estimates are sensitive to the method of estimation and data used:

Estimated Period
Periodicity of the return interval
Selection of an appropriate market index
Use of a smoothing technique
Adjustments for small-cap stocks

Neev Knowledge Management Pristine

www.edupristine.com

Beta and Cost of Capital for a Project

Arriving at a beta for a publically traded company is easy.
For companies which are not publically traded, estimating a beta requires proxying for the beta by
using the information on the project or company combined with a beta of a publically traded company.
This is done by Pure-Play Method
We use a comparable companys beta as a starting point.
asset

equity
1

(1 t)

D
E

Unlever the Beta as per the comparable companys debt:equity ratio

asset

equit y 1

D
1 t
E

Use the target companys debt to equity ratio to find the companys beta.

Neev Knowledge Management Pristine

www.edupristine.com

Example: Unlevered and Levered Beta

Small Apple Industries is planning to launch a new project. It has a marginal tax rate of 25%, Debt to
Total Assets ratio of 0.40. Its outstanding debt has a coupon of 6% and trading at a YTM of 7% in the
market. A similar publicly traded company, Big Apple, has a marginal tax rate of 35%, a Debt to Total
Assets ratio of 0.50. Its equity has a beta of 1.2. The expected return on the market portfolio is 13%.
Small Apples Beta is:
A) 1.20
B) 1.09
C) 0.98

Neev Knowledge Management Pristine

www.edupristine.com

Solution: Unlevered and Levered Beta

asset

equity
1

asset

(1 t)

D
E

1.2

1 (1 0.35)

0.7272

asset

asset

1
1

equit y 1

equity

equity

1 t

D
E

0.4
0.7272 1 (1 0.25)
0.6
1.0908

Neev Knowledge Management Pristine

www.edupristine.com