UNI

T5:THECOSTOFCAPI
TAL

5.
0AI
MSANDOBJECTI
VES

Af
tercompl
eti
ngt
hisuni
t,st
udent
sshoul
dbeabl
etounder
stand:

t
hemeani
ngofcostofcapi
tal

t
hei
mpl
i
cat
ionsoft
hecostofcapi
tal
ont
hev
alueofaf
ir
m,

f
ourmaj
orsour
cesofcapi
tal
toaf
ir
m andt
hei
rcost
,

t
hatt
hewei
ght
edav
eragecostofcapi
tal
isusedi
ninv
est
mentdeci
sions,

5.
1INTRODUCTI
ON

Asy
ouwel
lunder
stand,t
wopar
ti
esar
einv
olv
edi
naf
inanci
alassetundernor
mal

ci
rcumst
ances.Onei
sthepar
tyi
ssui
ngt
hef
inanci
alasset
.Anot
heri
stheonet
hat

buy
sori
nvest
sont
hef
inanci
alasset
.

Ther
ateofr
etur
nrequi
redbyt
hei
nvest
orshoul
ddef
ini
tel
ybepr
ovi
debysomeot
her

par
ty.Thepar
tywhi
chshoul
dpr
ovi
det
hei
nvest
ori
tsr
equi
redr
ateofr
etur
nist
he

i
ssui
ngpar
ty.Forexampl
e,i
fther
equi
redr
ateofr
etur
nbyani
nvest
oronagi
ven

bondi
s10%,t
hei
ssui
ngcompanyshoul
dpr
ovi
det
his10% t
othei
nvest
or.Thi
s

r
equi
redr
ateofr
etur
nthatshoul
dbemetbyt
hei
ssui
ngcompanybecomesi
tscost
.

Thi
sisacostont
hecapi
tal
thei
ssui
ngcompanywant
stor
aise.

Ther
efor
e,t
her
equi
red r
ateofr
etur
noni
nvest
ment
sinf
inanci
alasset
sbyt
he

i
nvest
ori
sthecostofcapi
talf
ort
hecompanyi
ssuedt
hef
inanci
alasset
s.But
,

gener
all
y,t
hecostofcapi
talf
ort
hei
ssui
ngcompanyi
shi
ghert
hant
her
equi
redr
ate

ofr
etur
n byt
hei
nvest
or.Thi
sisbecausewhen t
hei
ssui
ng companyi
ssuesa

f
inanci
alasset
,itmusti
ncursomecost
s.Thesecost
sincur
redbyt
hei
ssueri
n

r
elat
iont
oissuanceoff
inanci
alasset
sar
ecal
l
edf
lot
ati
oncost
s.Exampl
esi
ncl
ude

adv
ert
isi
ngcost
s,commi
ssi
onspai
dtot
hosesel
l
ingt
hef
inanci
alasset
s,costof

pr
int
ingdocument
s,cost
sofr
egi
str
ati
onwi
thgov
ernmentagenci
es,di
scount
sto

encour
aget
hesal
eofsecur
it
ies,
andsoon.

1
5.
2MEANI
NGOFTHECOSTOFCAPI
TAL

Thecostofcapi
tali
sthemi
nimum r
ateofr
etur
nthataf
ir
m mustear
ninor
dert
o

sat
isf
ytheov
eral
lrat
eofr
etur
nrequi
redbyi
tsi
nvest
ors.I
tisal
sot
hemi
nimum r
ate

ofr
etur
naf
ir
m mustear
noni
tsi
nvest
edcapi
talt
omai
ntai
nthev
alueoft
hef
ir
m

unchanged.Theseconddef
ini
ti
onconsi
der
sthecostofcapi
tal
asabr
eakev
enr
ate.

I
faf
ir
m’sact
ualr
ateofr
etur
nexceedsi
tscostofcapi
tal
,thev
alueoft
hef
ir
m woul
d

i
ncr
ease.I
font
heot
herhand,t
hecostofcapi
tali
snotear
ned,t
hef
ir
m’smar
ket

v
aluewi
l
ldecr
ease.Sot
hecostofcapi
tali
sther
ateofr
etur
nthati
sjustsuf
fi
cientt
o

l
eav
ethepr
iceoft
hef
ir
m’scommonst
ockunchanged.

Thecostofcapi
talser
vesasadi
scountr
atewhenaf
ir
m ev
aluat
esani
nvest
ment

pr
oposal
.Supposeaf
ir
misconsi
der
ingi
nvest
mentonapl
ant
.Thef
inancer
equi
red

f
ort
hisi
nvest
menti
stober
aisedbysel
l
ingacommonst
ocki
ssue.Now,
aft
err
aisi
ng

capi
tal
,thef
ir
misexpect
edt
opr
ovi
der
equi
redr
ateofr
etur
ntot
hosewhoi
nveston

t
hecommonst
ock.Thi
sinef
fecti
sthef
ir
m’scostofcapi
tal
.Sot
odeci
det
oinv
est

ont
hepl
ant
,themi
nimum r
ateofr
etur
nfr
om t
hei
nvest
mentatl
eastshoul
dbeequal

t
other
equi
redr
ateofr
etur
nbyt
hecommonst
ockhol
der
s.I
fther
equi
redr
ateof

r
etur
nbyt
hef
ir
m’scommonst
ockhol
der
sis13%,t
hent
hef
ir
m shoul
d ear
na

mi
nimum of13%oni
tsi
nvest
mentont
hepl
ant
.The13%mi
nimum r
ateofr
etur
nthat

shoul
dbeear
nedbyt
hef
ir
mis,
ther
efor
e,i
tscostofcapi
tal
.

5.
3MEASURI
NGTHESPECI
FICCOSTOFCAPI
TAL

Thecostofcapi
talf
oranypar
ti
cul
arcapi
talsour
ceorsecur
it
yissuei
scal
l
edt
he

speci
fi
ccostofcapi
tal
.Iti
sal
socal
l
edi
ndi
vi
dualcostofcapi
talorcomponentcost

ofcapi
tal
.

Eacht
ypeofcapi
tal
cont
ainedt
hecapi
tal
str
uct
ureofaf
ir
mincl
ude:

2
1.Debt 3.Commonst
ock

2.Pr
efer
redst
ock 4.Ret
ainedear
nings

Twoi
mpor
tantpoi
ntsy
oushoul
dbeari
nmi
ndaboutt
hespeci
fi
ccostofcapi
tal
.One

i
sthati
tiscomput
edonanaf
ter
-t
axbasi
s.Meani
ng,i
fther
ewoul
dbeanyt
ax

i
mpl
i
cat
ionont
hei
ndi
vi
dualsour
ceofcapi
tal
,itshoul
dbeconsi
der
ed.I
nal
mostal
l

ci
rcumst
ances,t
het
axi
mpl
i
cat
ioni
sonl
yondebtsour
cesoff
inance.Thesecond

poi
nti
sthatt
hespeci
fi
ccostofcapi
tali
sexpr
essedasanannualper
cent
ageorr
ate

l
i
ke6%,
9%,
or10%.Thecostofcapi
tal
isnotst
atedi
nter
msofbi
rr
s.

5.
5.1Thecostofdebt

Thi
sist
hemi
nimum r
ateofr
etur
nrequi
redbysuppl
i
ersofdebt
.Ther
elev
antspeci
fi
c

costofdebti
stheaf
ter
-t
axcostofnewdebt
.Gener
all
y,debti
sthecheapestsour
ce

off
inancet
oaf
ir
m and,
hence,
thecostofdebti
sthel
owestspeci
fi
ccostofcapi
tal
.

Ther
ear
etwobasi
cexpl
anat
ionsf
ort
his.Fi
rst
,debtsuppl
i
ers,
gener
all
y,assumet
he

l
owestr
iskamongal
lsuppl
i
ersofcapi
tal
.Theyr
ecei
vei
nter
estpay
ment
sbef
ore

pr
efer
redandcommondi
vi
dendsar
epai
d.Si
ncet
heyassumet
hesmal
l
estr
isk,
thei
r

r
etur
nist
hel
owest
.Thei
rlowestr
etur
nwoul
dbet
hel
owestcostofcapi
tal
tot
hef
ir
m.

Second,r
aisi
ngcapi
talt
hroughdebtsour
cesent
ail
sint
erestexpense.Thei
nter
est

expensei
ntur
nreducest
hef
ir
m’si
ncomewhi
chul
ti
mat
elywoul
dcauset
axpay
ment

t
ober
educed.Sor
aisi
ngmoneyi
nthef
orm ofdebtr
esul
tsi
nthesmal
l
estt
axbur
den,

andf
inal
l
y,t
hef
ir
m’scostofdebtwoul
dbet
hel
owest
.

Debtsour
cesoff
inancemayt
akesev
eralf
ormsl
i
kebonds,pr
omi
ssor
ynot
es,bank

l
oans.Her
e,f
orourconv
eni
enceweconsi
derbondi
ssuet
oil
l
ust
rat
ethecostofdebt
.

Comput
ingt
hecostofnewbondi
ssuei
nvol
vest
hreest
eps:

i
)Det
ermi
net
henetpr
oceedsf
rom t
hesal
eofeachbond

NPd=Pd–f

Wher
e:

3
 NPd=Thenetpr
oceedsf
rom t
hesal
eofeachbond

Pd=Themar
ketpr
iceoft
hebond

f=Fl
otat
ioncost
s

i
i
) Comput
ethe ef
fect
ive bef
oret
ax costof t
he bond usi
ng t
he f
oll
owi
ng

appr
oxi
mat
ionf
ormul
a:

Kd=

Wher
e:

Kd=Theef
fect
ivebef
oret
axcostofdebt

I=Annual
int
erestpay
ment

Pn=Theparv
alueoft
hebond

n=Lengt
hoft
hehol
dingper
iodoft
hebondi
nyear
s.

i
i
i)Comput
etheaf
ter
-t
axcostofdebt

Kdt=Kd(
1–t
)

Wher
e:

Kdt=Theaf
ter
-t
axcostofdebt

t=Themar
ginal
taxr
ate

Exampl
e:Cur
rent
ly,Aby
ssi
niaI
ndust
ri
alGr
oupi
spl
anni
ngt
osel
l15-
year
,Br
.1,
000

par
-val
uebondst
hatcar
rya12% annualcouponi
nter
estr
ate.Asar
esul
tofl
ower

cur
renti
nter
estr
ates,
Aby
ssi
niabondscanbesol
dforBr
.1,
010each.Fl
otat
ioncost
s

ofBr
.30perbondwi
l
lbei
ncur
redi
nthepr
ocessofi
ssui
ngt
hebonds.Thef
ir
m’s

mar
ginal
taxr
atei
s40%.

Requi
red:Cal
cul
atet
heaf
tert
axcostofAby
ssi
nia’
snewbondi
ssue:

Sol
uti
on:

Gi
ven:
Pn=Br
.1,
000;
I=Br
.120(
Br.1,
000x12%)
;n=15;
Pd=Br
.1,
010;
f=Br
.30;

t=40%;
Kdt=?

4
Thenappl
ythet
hreest
eps:

i
)NPd=Br
.1,
010–Br
.30=Br
.980

i
i
)Kd=

i
i
i)Kdt=12.
26%(
1–40%)=7.
36%

Ther
efor
e,t
heaf
ter– t
axcostofAby
ssi
nia’
snew bondi
ssuei
s7.
36%.Thati
s,

Aby
ssi
nia shoul
d beabl
eto ear
n a mi
nimum of7.
36% t
o sat
isf
ybondhol
der
s.

Ot
her
wise,
thef
ir
m’sv
aluewi
l
ldecl
i
ne.

5.
5.2Thecostofpr
efer
redst
ock

Thecostofpr
efer
redst
ocki
sthemi
nimum r
ateofr
etur
naf
ir
m mustear
ninor
dert
o

sat
isf
yther
equi
redr
ateofr
etur
noft
hef
ir
m’spr
efer
redst
ocki
nvest
ors.I
tisal
sot
he

mi
nimum r
ateofr
etur
naf
ir
m’spr
efer
redst
ocki
nvest
orsr
equi
rei
ftheyar
eto

pur
chaset
hef
ir
m’spr
efer
redst
ock.

Whenaf
ir
mrai
sescapi
talbyi
ssui
ngnewpr
efer
redst
ock,i
tisexpect
edt
opayf
ixed

amountofdi
vi
dendst
othepr
efer
redst
ockhol
der
s.Soi
tist
hedi
vi
dendpay
mentt
hat

i
sthecostoft
hepr
efer
redst
ockt
othef
ir
m st
atedasanannual
rat
e.

Thecostofanewpr
efer
redst
ocki
ssuecanbecomput
edbyf
oll
owi
ngt
wost
eps:

i
)Det
ermi
net
henetpr
oceedsf
rom t
hesal
eofeachpr
efer
redst
ock.

NPpf=Ppf–f

Wher
e:

NPpf=Netpr
oceedsf
rom t
hesal
eofeachpr
efer
redst
ock

Ppf=Mar
ketpr
iceoft
hepr
efer
redst
ock

f=Fl
otat
ioncost
s

i
i
)Comput
ethecostofpr
efer
redst
ocki
ssue

Kps= Dps_
_

5
 NPpf

Wher
e:

Kps=Thecostofpr
efer
redst
ock

DPs=Thepershar
eannual
div
idendont
hepr
efer
redst
ock

Exampl
e:Sef
aComput
erSy
stemsCompanyhasj
usti
ssuedpr
efer
redst
ock.The

st
ockhas12%annualdi
vi
dendandBr
.100parv
alueandwassol
dat102%oft
hepar

v
alue.I
naddi
ti
on,f
lot
ati
oncost
sofBr
.2.
50pershar
emustbepai
d.Cal
cul
atet
he

costoft
hepr
efer
redst
ock.

Sol
uti
on:

Gi
ven:
Pps=Br
.102(
Br.100x102%)
;Dps=Br
.12(
Br100x12%)
;f=Br
.2.
50;

Kps=?

Thenappl
ythet
wost
eps:

i
)NPpf=Br
.102–Br
.2.
50=Br
.99.
50

i
i
)Kps= Br
.12 =12.
06%

Br
.99.
50

Ther
efor
e,Sef
aCompanyshoul
dbeabl
etoear
nami
nimum of12.
06% onany

i
nvest
mentf
inancedbyt
henewpr
efer
redst
ocki
ssue.Ot
her
wise,
thef
ir
m’sv
aluewi
l
l

decr
ease.

Checky
ourpr
ogr
essI
I

Sat
tel
i
teShar
eCompanypl
anst
osal
epr
efer
redst
ockwi
thparv
alueofBr
.50per

shar
e.Thei
ssuei
sexpect
edt
opayquar
ter
lydi
vi
dendsofBr
.1.
25pershar
eandt
o

hav
efl
otat
ioncost
sof6%oft
heparv
alue.Thepr
efer
redst
ocksel
l
sat95%ofi
tspar
.

Requi
red:Cal
cul
atet
hecostofpr
efer
redst
ockt
oSat
ell
i
teShar
eCompany
.

3.
3.3Thecostofcommonst
ock

Thecostofcommonst
ocki
sthemi
nimum r
ateofr
etur
nthataf
ir
m mustear
nfori
ts

6
commonst
ockhol
der
sinor
dert
omai
ntai
nthev
alueoft
hef
ir
m.Af
ir
m doesnot

makeexpl
i
citcommi
tmentt
opaydi
vi
dendst
ocommonst
ockhol
der
s.Howev
er,
when

commonst
ockhol
der
sinv
estt
hei
rmoneyi
nacor
por
ati
on,t
heyexpectr
etur
nsi
nthe

f
orm ofdi
vi
dends.Ther
efor
e,commonst
ocksi
mpl
i
cit
lyi
nvol
vear
etur
nint
ermsof

t
hedi
vi
dendsexpect
edbyi
nvest
orsandhence,
theycar
rycost
.

Gener
all
y,commonst
ockdi
vi
dendsar
epai
daf
teri
nter
estandpr
efer
reddi
vi
dendsar
e

pai
d.Asar
esul
t,commonst
ocki
nvest
orsassumet
hemaxi
mum r
iski
ncor
por
ate

i
nvest
ment
.Theycompensat
ethemaxi
mum r
iskbyr
equi
ri
ngt
hehi
ghestr
etur
n.Thi
s

hi
ghestr
etur
nexpect
edbycommonst
ockhol
der
smakecommonst
ockt
hemost

expensi
vesour
ceofcapi
tal
.

Thecostofcommonst
ockcanbecomput
edusi
ngt
heconst
antgr
owt
hval
uat
ion

model
.

Ks= D1+g

NPo

Wher
e:

Ks=Thecostofnewcommonst
ocki
ssue

D1=Theexpect
eddi
vi
dendpay
mentatt
heendofnexty
ear

NPo=Netpr
oceedsf
rom t
hesal
eofeachcommonst
ock

g=Theexpect
edannual
div
idendsgr
owt
hrat
e

Thenetpr
oceedsf
rom t
hesal
eofeachcommonst
ock(
NPo)i
scomput
edasf
oll
ows:

NPo=Po–f

Wher
e:

Po=Thecur
rentmar
ketpr
iceoft
hecommonst
ock

f=f
lot
ati
oncost
s

Exampl
e:Ani
ssueofcommonst
ocki
ssol
dtoi
nvest
orsf
orBr
.20pershar
e.The

i
ssui
ngcor
por
ati
oni
ncur
sasel
l
ingexpenseofBr
.1pershar
e.Thecur
rentdi
vi
dendi
s

Br
.1.
50pershar
eandi
tisexpect
edt
ogr
owat6%annualr
ate.Comput
ethespeci
fi
c

7
costoft
hiscommonst
ocki
ssue.

Sol
uti
on

Gi
ven:
Po=Br
.20;
Do=Br
.1.
50;
g=6%;
f=Br
.1;
Ks=?

Thenappl
ythet
wost
eps:

i
)NPo=Br
.20–Br
.1=Br
.19

)Ks= D1 +g=Br
i
i .1.
50(
1.06)=14.
37%

Npo Br
.19

Ther
efor
e,t
he f
ir
m shoul
d be abl
eto ear
n a mi
nimum r
etur
n of14.
37% on

i
nvest
ment
sthatar
efi
nancedbyt
henewcommonst
ocki
ssue.

Checky
ourpr
ogr
essI
II

Repent
anceCor
por
ati
on’
sshar
eofcommonst
ocki
scur
rent
lysel
l
ingatBr
.75.The

f
ir
m’spr
oject
eddi
vi
dendpershar
edur
ingt
henexty
eari
sBr
.3.
38andt
heexpect
ed

di
vi
dendgr
owt
hrat
eis8%.Becauseofcompet
it
ivenat
ureoft
hemar
ketaBr
.3per

shar
eunderpr
ici
ngi
snecessar
y.I
naddi
ti
on,
thesal
eofnewcommonst
ocki
nvol
ves

under
wri
ti
ngf
eeofBr
.0.
60pershar
eandot
herf
lot
ati
oncost
sofBr
.0.
90pershar
e.

Requi
red:Cal
cul
atet
hecostofcommonst
ockf
orRepent
anceCor
por
ati
on.

5.
5.4ThecostofRet
ainedEar
nings

Ret
ained ear
ningsr
epr
esentpr
ofi
tsav
ail
abl
eforcommon st
ockhol
der
sthatt
he

cor
por
ati
onchoosest
orei
nvesti
nit
sel
frat
hert
hanpay
outasdi
vi
dends.Ret
ained

ear
ningsar
enotsecur
it
iesl
i
kest
ocksandbondsandhencedonothav
emar
ketpr
ice

t
hatcanbeusedt
ocomput
ecost
sofcapi
tal
.

The costofr
etai
ned ear
nings i
sthe r
ate ofr
etur
n a cor
por
ati
on’
s common

st
ockhol
der
sexpectt
hecor
por
ati
ont
oear
nont
hei
rrei
nvest
edear
nings,atl
east

equalt
other
ateear
nedont
heout
standi
ngcommonst
ock.Ther
efor
e,t
hespeci
fi
c

costofcapi
talofr
etai
nedear
ningsi
sequat
edwi
tht
hespeci
fi
ccostofcommon

st
ock.Howev
er,
flot
ati
oncost
sar
enoti
nvol
vedi
nthecaseofr
etai
nedear
nings.

8
Comput
ingt
hecostofr
etai
nedear
ningsi
nvol
vesj
ustasi
ngl
epr
ocedur
eofappl
yi
ng

t
hef
oll
owi
ngf
ormul
a:

Kr=D1+g

Po

Wher
e:

Kr=Thecostofr
etai
nedear
nings

D1=Theexpect
eddi
vi
dendspay
mentatt
heendofnexty
ear

Po=Thecur
rentmar
ketpr
iceoft
hef
ir
m’scommonst
ock

g=Theexpect
edannual
div
idendgr
owt
hrat
e.

Exampl
e:Zei
l
aAut
oSpar
ePar
tsManuf
act
uri
ngcompanyexpect
stopayacommon

st
ockdi
vi
dendofBr
.2.
50pershar
edur
ingt
henext12mont
hs.Thef
ir
m’scur
rent

commonst
ockpr
icei
sBr
.50pershar
eandt
heexpect
eddi
vi
dendgr
owt
hrat
eis7%.

Af
lot
ati
oncostofBr
.3i
sinv
olv
edt
osal
eashar
eofcommonst
ock.

Requi
red:Comput
ethecostofr
etai
nedear
nings

Sol
uti
on

Gi
ven:
Po=Br
.50;
D1=Br
.2.
50;
g=7%;
Kr=?

Thenappl
ythef
ormul
a:

Kr=D1+g= Br
.2.
50+7%=12%

Po Br
.50

Checky
ourpr
ogr
essI
V

Zequal
aText
il
esShar
eCompanywi
shest
omeasur
eit
scostofr
etai
nedear
nings.

Thef
ir
m’sst
ocki
scur
rent
lysel
l
ingf
orBr
.57.
50.Thef
ir
m expect
stopayBr
.3.
40

di
vi
dendatt
heendoft
hey
ear
.Theexpect
eddi
vi
dendgr
owt
hrat
eis8%.

Requi
red:Det
ermi
net
hcostofr
etai
nedear
nings.

5.
4WEI
GHTEDAVERAGECOSTOFCAPI
TAL(
WACC)

9
I
nthepr
evi
oussect
ionwehav
eseenhow t
ocomput
ethecostofcapi
talf
oreach

i
ndi
vi
dualsour
ceofcapi
tal
.Thespeci
fi
ccostofcapi
tali
susedi
nev
aluat
ingan

i
nvest
mentpr
oposalt
o be f
inanced by a par
ti
cul
arcapi
talsour
ce.Pr
act
ical
l
y,

howev
er,i
nvest
mentar
efi
nancedbyt
woormor
esour
cesofcapi
tal
.Insucha

si
tuat
ion,
wecannotmakeuseoft
hei
ndi
vi
dualcostofcapi
tal
.Rat
herweshoul
duse

t
heav
eragecostofcapi
tal
empl
oyedbyt
hef
ir
m.

Thef
ir
m’scapi
talst
ruct
urei
scomposedofdebt
,pr
efer
redst
ock,
commonst
ock,
and

r
etai
nedear
nings.Eachcapi
talsour
ceaccount
stosomepor
ti
onoft
het
otalf
inance.

Butt
heper
cent
agecont
ri
but
ionofonesour
cei
susual
l
ydi
ff
erentf
rom anot
her
.So

wemustcomput
ethewei
ght
ed av
eragecostofcapi
talr
athert
han t
hesi
mpl
e

av
erage.

The wei
ght
ed av
erage costofcapi
tal(
WACC)i
sthe wei
ght
ed av
erage oft
he

i
ndi
vi
dualcost
sofdebt
,pr
efer
redst
ockandcommonequi
ty(
commonst
ockand

r
etai
nedear
nings)
.Iti
sal
socal
l
edt
hecomposi
tecostofcapi
tal
.

I
fthewei
ght
soft
hecomponentcapi
talsour
cesar
eal
lgi
ven,t
hewei
ght
edav
erage

costofcapi
tal
canbecomput
edas:

WACC=WdKdt+WpsKps+WceKs

Wher
e:

WACC=Thewei
ght
edav
eragecostofcapi
tal

Wd=Thewei
ghtofdebt

Wps=Thewei
ghtofpr
efer
redst
ock

Wce=Thewei
ghtofcommonequi
ty

Kdt=Theaf
ter–t
axcostofdebt

Kps=Thecostofpr
efer
redst
ock

Ks=Thecostofcommonequi
ty

TheWACC i
sfoundbywei
ght
ingt
hecostofeachspeci
fi
cty
peofcapi
talbyi
ts

pr
opor
ti
oni
nthef
ir
m’scapi
tal
str
uct
ure.Wei
ght
soft
hei
ndi
vi
dual
capi
tal
sour
cescan

10
 becal
cul
atedbasedont
hei
rbookv
alueormar
ketv
alue.

Toi
l
lust
rat
ethecomput
ati
onoft
heWACC,
lookatt
hef
oll
owi
ngexampl
e.

MunaTool
sManuf
act
uri
ng Company
’sf
inanci
almanagerwant
sto comput
ethe

f
ir
m’swei
ght
edav
eragecostofcapi
tal
.Thebookandmar
ketv
aluesoft
heamount
s

aswel
lasspeci
fi
caf
ter
-t
axcost
sar
eshowni
nthef
oll
owi
ngt
abl
eforeachsour
ceof

capi
tal
.

Sour
ceofcapi
tal Bookv
alue Mar
ketv
alue Speci
fi
ccost

Debt Br
.1,
050,
000 Br
.1,
000,
000 5.
3%

Pr
efer
redst
ock 84,
000 125,
000 12.
0

Commonequi
ty 966,
000 1,
375,
000 16.
0

Tot
al Br
.2,
100,
000 Br
.2,
500,
000

Requi
red:Cal
cul
atet
hef
ir
m’swei
ght
edav
eragecostofcapi
tal
usi
ng:

1)bookv
aluewei
ght
s

2)mar
ketv
aluewei
ght
s

Sol
uti
on:

1)Tot
albookv
alue=Br
.2,
100,
000

Wd=Br
.1,
050,
000=0.
5;Wps=Br
.84,
000_
_=0.
04;
Wce=Br
.966,
000=0.
46

Br
.2,
100,
000 Br
.2,
100,
000 Br
.2,
100,
000

WACC=WdKdt+WpsKps+WceKs

=0.
5(5.
3%)+0.
04(
12.
0%)+0.
46(
16.
0%)

=2.
65%+0.
48%+7.
36%

=10.
49%

Themi
nimum r
ateofr
etur
nonal
lpr
oject
sshoul
dbe10.
49%.Meani
ng,Munashoul
d

acceptal
lpr
oject
ssol
ongast
heyear
nar
etur
ngr
eat
ert
hanorequal
to10.
49%

2)Tot
alMar
ketv
alue=Br
.2,
500,
000

Wd=Br
.1,
000,
000=0.
4;Wps=Br
.125,
000=0.
05;
Wce=Br
.1,
375,
000=0.
55

Br
.2,
500,
000 Br
.2,
500,
000 Br
.2,
500,
000

11
 WACC=0.
4(5.
3%)+0.
05(
12.
0%)+0.
55(
16.
0%)

=2.
12%+0.
60%+8.
80%

=11.
52%

I
fthe mar
ketv
alue wei
ght
s ar
e used,Muna shoul
d acceptal
lpr
oject
s wi
tha

mi
nimum r
ateofr
etur
nof11.
52%.

12