Video Transcript: Weighted Average Cost of Capital

hello, welcome. We're going to discuss the weighted average cost of capital.  What is capital? Capital is money used to start or run a business. It's the cash  that we have. We need capital to ensure that we can continue to run our  operations smoothly. Where does capital come from? You can obtain capital  from borrowing from banks, which is debt or owners, investors, put their own  money in the company, and it is called equity. What is the weighted average cost of capital? The weighted average cost of capital is a calculation of a firm's cost  of capital in which each category of capital is proportionally weighted, all  sources of capital, including common stock, preferred stock, bonds and in the in  any other long term debt, are included in a weight weighted average cost of  capital calculation. A firm's weighted average cost of capital increases as the  beta and the rate of return on equity increase as an increase in weighted  average cost of capital, this denotes a decrease in valuation and an increase in  risk. Debt and equity are the two components that constitute a company's capital funding lenders and equity holders will expect to receive a certain return on the  funds or capital they have provided. Since cost of capital is the return that equity owners or shareholders and debt holders will expect. So weighted average cost  of capital indicates the return that both kinds of stakeholders, equity owners and  debt lenders can expect to receive. Put another way, weighted average cost of  capital is an investor's opportunity cost of taking on the risk of investing money  in a company. So variables needed to calculate weighted average cost of  capital. So first, we'll have to know how our capital structure is weighted in  common equity, how is it weighted in preferred equity? What is the weight of our  debt structure? Then we need to know the cost of capital for our common equity  or the expected return. What is the cost of capital on preferred equity, or the  expected return on equity for preferred shares. Now, what is our cost of debt?  That will be the interest rate we pay on our financing, and then T is the marginal  corporate tax rate. So let's work a weighted average cost of capital, example. So sand street Inc went public by issuing 1 million shares of common stock at $25  per share, the shares are currently trading at $30 per share. The current risk  free rate is 4% the market risk premium is 8% and the company has a beta  coefficient of 1.2 during last year, it issued 50,000 bonds at $1,000 par or face  value that is paying a 10% coupon annually, maturing in 20 years. These bonds  are currently trading at $950 the tax rate is 30% we need to calculate the  weighted average cost of capital. So first, we need to calculate the proportion of  equity and debt in sand Street and their structure. So the current market value of equity, right? So we have, so we have a million shares of common stock. So we  need to know our equity value. So we have a million shares times $30 per  share, because that is the current market price, or currently trading at $30 okay,  we want to know the current market value of our Debt, current market value of  debt, current market value, okay? 50,000 $1,000 face value bonds are now  trading at $950 right? So let's calculate our market value of equity, $30 times a 

million is 30 million in equity. 50,000 times 950 is 47,500 or 47,500,000 so our  total market value. Of debt and equity, 77,000 or 77,500,000 so our total capital  structure, this is our total capital. This is all of our capital from equity and debt.  This is all the cash. This is all of the cash. This is all the equity value, right? This  our total capital value, total capital value, 77,500,000 so now we need to  calculate the weight of equity. So we know we have 30 million in equity due to  the million shares outstanding times $30 stock price. So we want to find the  weight of equity equals 30 million divided by 77,000,500 so we want to know  what percentage of the 77,500,000 what percentage of that is made up of equity. So we find that out. Where we take 30 million divided by 77.5 million, right? And  we get 38.71 38.71% so out of our capital structure, we are financed by equity  38.71% so we are financed by equity at 38.71% so now we need to calculate  our weight of debt. All right, so we have 47,500,000 in total debt, 50,000 bonds  currently trading at 950 gives us 47,500,000 so we want to know what  percentage of debt we have for our capital structure. So we'll divide by the total  capital value, 77,500,000 and we'll get 61.29% so now we need to estimate cost of of equity and after tax, cost of debt. We can estimate cost of equity using  either the dividend discount model or capital asset pricing model so we  remember cap M Right, rate of risk free, plus the return from the market, minus  the risk free rate times beta, right? So we'll use the CAPM model to find out our  after tax cost of equity. So from our current example, we can see that the risk  free rate is 4% plus the risk market risk premium is 8% so the return on the  market minus risk free, and then our beta is 1.2 after this calculation, it'll give  you 13.6% so the cost of debt is equal to the yield to maturity of the bonds. With  the given data, we can find that the yield to maturity is 10.61% so our weighted  average cost of capital is calculated like this. So weighted average cost of  capital is the weight of our common stock times the rate of return on our  common stock, plus the weight of preferred stock times the return on the  preferred stock, plus the weight of debt times the return on the debt, one minus  the tax rate. So we'll have our after tax adjusted cost of capital. So for this  example, remember notice we don't have we don't have any preferred shares to  worry about. And this example, we only have common stock and debt financing.  So our weight of. Common stock. Remember, with 38.71% we're going to  multiply that by the 13.6 on the CAPM. Remember, that's our return for our  common stock. Then we'll add that to the weight 61.29 and we'll multiply that by  the return on debt, 7.427 after tax. So in the order of operations, we took the tax  rate, remember, we took the tax rate at 30% was the tax rate, right? So we got  our after tax cost of debt at 7.427% so we took the return on debt at 10.61 and  we multiplied it by one minus the tax rate to give us the 7.42 and our average  weighted average cost of capital after we do the calculation, 9.8166 so we want  to know out of our capital structure, we'll be weighted in equity. We'll be  weighted in debt. At some figure, we'll have a return that we need to pay out to 

investors, and we'll have interest payments that we have to pay out to lenders,  taking the weight and multiply them by the returns and add them together from  the equity and the debt side, will give you your weighted average cost of capital,  in this case, 9.8%