Determining The Cost Of Capital Essay example

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If the company has used different methods of financing, then the cost of capital is calculated by the weighted average cost of capital. The above formulas are also needed in this method.

The method for calculating WACC is often expressed in the following formula:

WACCC = percentage of financing that is equity * cost of equity + percentage of financing that is debt * cost of debt * (1 – corporate tax rate)

In order to calculate the percentage of financing that is equity, you need the following formula:

Percentage of financing that is equity = market value of the firm’s equity / total market value of the firm’s financing (equity and debt)

To calculate the percentage of financing that is debt, you can use the following formula:

Percentage of financing that is debt= market value of the firm’s debt / total market value of the firm’s financing (equity and debt)

The WACC will increase if the beta (risk measure) and the rate of return on equity increases. This is because a growing WACC denotes a drop in valuation and growth in risk.

You can also find out the above information from this informative YouTube video:

An example calculation

To make the above formulas a bit less daunting, here’s an example calculation of WACC. The below calculation is a rather simplified version of the different factors that might influence the rates used in the calculation. To ensure you come up with the most accurate figure for the cost of capital, you also need to check out the common problems in calculating it in the following section.

In our example, the crucial figures in WACC are as follows:

The company’s total equity = \$10,000
The company’s total debt = \$3,000

The percentage of financing that is equity + 12.5%
The percentage of financing tha...

... middle of paper ...

...Limitations of WACC

Finally, you also need to keep in mind the limitations of WACC.As well as the above issues; overall, it is crucial to remember the elements used in the formula are not consistent. These subtle differences can be apparent in the basic calculations of how the company calculates its debt as well as its equity.

The final ratio you receive with WACC should therefore not be taken as an ultimate truth. Instead, you want to use the cost of capital as an important indicator, but also add other financial metrics to your analysis and decision-making process. This is also an important point to remember if you are considering investing in a company.

The more you know about the financial status of the company to better. While the cost of capital needs to be taken with a pinch of salt and tough analysis, it is nonetheless an essential metric to learn about.

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