26-08-2016, 02:35 PM
1444835825-WACC.xls (Size: 31.5 KB / Downloads: 26)
In the tutorial on Present Value, we demonstrated that the greater the "riskiness" of a future cash flow, the lower its present value. We also explained that "riskiness" is measured by the percentage return expected from an alternative investment with the same amount of risk. The "Cost of Capital" calculation quantifies that risk.
What Does "Cost of Capital" Mean?
More specifically, "cost of capital" is defined as "the opportunity cost of all capital invested in an enterprise."
Let's dissect this definition:
Opportunity cost is what you give up as a consequence of your decision to use a scarce resource in a particular way.
All capital invested is the total amount of cash invested into a business.
In an enterprise refers to the fact that we are measuring the opportunity cost of all sources of capital which include debt and equity.
How Do We Calculate a Company's Weighted Average Cost of Capital?
We calculate a company's weighted average cost of capital using a 3 step process:
1. Cost of capital components. First, we calculate or infer the cost of each kind of capital that the enterprise uses, namely debt and equity.
A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the company's debt, adjusted for the tax-deductibility of interest expenses. Specifically:
The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in %)
We enter the marginal tax rate in cell C10 of worksheet "Inputs."