EstatePass

Business Finance · Module 4: Sources and cost of finance

One WACC, Three Wrong Turns

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Chapters

  1. Case
  2. Weights
  3. Costs
  4. WACC
  5. Recap

In short

WACC weights each source of finance by its market value, uses the after-tax cost of debt, and takes the cost of equity from CAPM. For Kurrajong Ltd that gives equity of $70m and debt of $28.8m, a cost of equity of 11.15%, an after-tax cost of debt of 4.55%, and a WACC of 9.23%.

  • Weight equity and debt at market value, not book or face value.
  • Cost of debt after tax: pre-tax rate × (1 − tax rate).
  • Cost of equity from CAPM: risk-free rate + beta × market risk premium.

Transcript

Case

One WACC question, four answers. Three are just one step away from right. Let's work it out, and see exactly where each wrong turn happens.

Weights

Kurrajong has 20 million shares, trading at $3.50. So its equity is worth $70 million on the market. Its debentures have a face value of $30 million, but trade at $96 per $100. So the debt is worth $28.8 million. Together, $98.8 million. The balance sheet shows $40 million of equity. Ignore it: WACC uses market values.

Costs

Cost of equity, from CAPM: 4%, plus a beta of 1.1 times a 6.5% premium. That makes 11.15%. Debt costs 6.5% before tax. But interest is deductible, at 30%. Pause. What does the debt cost after tax? 4.55%: 6.5% times 0.7.

WACC

Now weight them: 70 of equity and 28.8 of debt, out of 98.8. The WACC is 9.23%. That is answer D. Forget the tax shield on debt, and you get 9.79%. Use the book values, 40 and 30, and you get 8.32%. Take the debt at face value, and you get 9.17%.

Recap

Market weights. After-tax debt. CAPM for equity. Check all three. Next: practice Module 4 in the CPA dashboard while it is fresh. Subscribe so you catch the next lesson.

Try a question on this lesson

From the EstatePass Business Finance bank. Answer it, then read the explanation.

Question 1 of 10/0 correct

Kurrajong Ltd has 20,000,000 ordinary shares trading at $3.50 (book value of equity $40,000,000) and debentures with a face value of $30,000,000 trading at $96 per $100. The pre-tax cost of debt is 6.5% p.a. The risk-free rate is 4.0%, the market risk premium is 6.5% and the equity beta is 1.1. The company tax rate is 30%. Using market-value weights and the CAPM, what is the WACC, to two decimal places?

Sources

  • Weighted average cost of capital (market-value weights)
  • Capital asset pricing model (Sharpe 1964)
  • CPA question bank: cpa-bf-0045

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