Cost of capital
Components of WACC
Weighted average cost of capital is the average return required by providers of long-term finance, weighted by market values. Cost of equity can be estimated by the dividend valuation model, Ke = D1/P0 + g, or CAPM, Ke = Rf + beta times (Rm minus Rf). Cost of debt for irredeemable debt is after-tax interest divided by market price; for redeemable debt use the IRR of after-tax interest and redemption proceeds. Preference shares use the dividend yield. Use market values, not book values, and after-tax cost of debt because interest is tax-deductible.
Risk and adjustments
WACC assumes the project has the same business risk and gearing as existing operations. For a different project, use a risk-adjusted WACC based on a proxy company's asset beta. Ungear the proxy's equity beta, regear at the target gearing, then apply CAPM. CAPM assumes diversified investors, efficient markets and a single-period horizon; it ignores transaction costs and taxes in its basic form.
Traps and rule of thumb
Traps: using cum-div price when D1 is next year's dividend; forgetting to deduct issue costs; using historical book weights; applying the existing WACC to a completely different division. Rule of thumb: WACC = (E/V)Ke + (D/V)Kd(1 minus T), using market values and after-tax debt.
Worked example: equity market value $600m, debt $400m, Ke 12%, pre-tax Kd 8%, tax 25%. After-tax Kd = 6%. WACC = 0.6 times 12% + 0.4 times 6% = 9.6%.