WEIGHTED AVERAGE COST OF CAPITAL

Prescribed Textbook: Financial Management

Chapter 7

• Understand the concept of the weighted average cost of capital (WACC)

• Determine the cost of debt
• Determine the cost of preference share capital
• Calculate the cost of equity
• Understand the practical issues of estimating the CAPM parameters

LEARNING • Understand how a firmʼs capital structure affects a firmʼs WACC

• Calculate firmʼs weighted average cost of capital (WACC)

OBJECTIVES Exclusions:
• References to EVA
• Relevering & unlevering beta
• Fama‐ French models
• Break in WACC

Please note the list of learning objectives given each week per topic are not exhaustive,
as there are various links between topics. Students should ensure that they are
comfortable with all concepts tested in the tutorials, question bank questions and past
papers and should use this list to establish whether they have achieved the basic
learning objectives
SETTING THE SCENE

Investment Financing Dividend

Decision Decision Decision

INVEST

Investment EARN
Decision
SETTING THE SCENE

Year 1 Year 2 Year 3 Year 4 Year 5

R 100 R 200 R 300 R 400 R 500

What is this PV= 100 + 200 +300 +400 +500

investment
worth today ? Time value of PV= Cash flows discount at a
money discount rate WACC
SETTING THE SCENE
 WHY IS CAPITAL STRUCTURE IMPORTANT?
Year 1 Year 2 Year 3 Year 4 Year 5
Cash flows 100 100 100 100 100
Discount rate 10%
PV R 379.08

Year 1 Year 2 Year 3 Year 4 Year 5

Cash flows 100 100 100 100 100
Discount rate 15%
PV R 335.22

Year 1 Year 2 Year 3 Year 4 Year 5

Cash flows 100 100 100 100 100
Discount rate 5%
PV R 432.95
 M&M THEORIES‐ CASE III (cont.)

Conclusion:
A certain balance between debt and equity optimises firm value
 WEIGHTED AVERAGE COST OF CAPITAL

The Weighted average cost of capital (WACC) is the average rate of

return a company expects to compensate all its different investors. The
What does WACC mean? weights are the fraction of each financing source in the company’s
target capital structure.

The target (optimal) capital structure is defined as the mix of

Target capital structure “permanent” debt, preference shares and ordinary equity that will
maximise the company's value.

Evaluation of capital projects/ investments

Uses of WACC Valuation of companies
Determination of a company’s EVA (You will do in Manfin IV)
WACC FORMULA
 APPROACHING A WACC CALCULATION
Step 1 Step 2a Step 2b

• Identify • Calculate • Calculate the

permanent market value cost/ return
capital of each (after tax) of
component each
component

Step 3 Step 4 Step 5

• Calculate the • Calculated the • Calculate the
weighting of weighted cost/ WACC
each return of each
component component
APPROACHING A WACC CALCULATION cont.

Step 1 Step 2a Step 2b Step 3 Step 4

Capital Market value Cost/ return Weighting Weigthed return

Total MV WACC
Step 5
 STEP 1‐ IDENTIFYING PERMANENT CAPITAL
Not
COMPANY A
Permanent “accounting
Extract of Statement of Financial Position at 28 February 2025 items”
EQUITIES AND LIABILITIES
Equities Note 1
Share Capital 2 000 The redeemable preference shares will be redeemed
Retained Earnings 1 040 in 12 months’ time and management has no intention
13% non-redeemable preference shares 300 of replacing them.
Liabilities
12% Redeemable preference shares 1 100 Note 2
8% Debentures 2 500 The debentures are redeemable in two months’ time.
Deferred tax 10 They will be replaced with similar debentures which
will be redeemed six years after their issue.
Accounts payable 270
Overdraft facility 3 80 Note 3
The overdraft facility always has an average balance of
Total Equity and Liabilities 4 300 R80 million.
 STEP 1‐ IDENTIFYING PERMANENT CAPITAL

Step 1 Step 2a Step 2b Step 3 Step 4

Capital Market value Cost/ return Weighting Weigthed return
Share Capital
Retained Earnings Accounting Adjustment
Non‐redeemable
preference shares
Redeemable
Short term
preference shares
8% Debentures
Accounting Adjustment
Deferred tax
Accounts payable Short term
Overdraft facility
Total MV WACC
Step 5
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT
Why is step 2a
COMPANY A necessary?
Extract of Statement of Financial Position at 28 February 2021

EQUITIES AND LIABILITIES

Book value Market value
Equities
Share Capital 2 000
Retained Earnings 1 040
13% non-redeemable preference shares 300
Non‐current liabilities
12% Redeemable preference shares 1 100 WACC: investors
8% Debentures 2 500 required return
Deferred tax 10
Current liabilities
Accounts payable 270 Investors demand a
Overdraft facility 3 80 market related return
Total Equity and Liabilities 4 300
Total
(not per share)
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Debt
Redeemable bond

Face value = R 100

Redemption date= 5 years
Coupon rate = 15%
Market yield (YTM) = 9%
PV= 123.34

Market value calculation

FV= 100
N= 5
i= 9%
PMT = 15 (100*15%)

Solve PV
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Preference shares
Types of preference shares

• Redeemable vs Irredeemable / non‐ redeemable

• Cumulative vs Non‐ cumulative
• Convertible

Redeemable Non‐redeemable

Generally identical to redeemable debt PV= Dividend / Kp (cost of the preference share)

Face value = R100, coupon rate = 15% per [Link]

the required return is 9%

PV= (100* 15%) / 9%

PV= R 166,67
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Preference shares
Cumulative Irredeemable Preference Shares
Yo Y1 Y2 Y3 Y4
An investor owns 100 cumulative, irredeemable
preference shares in Company X, with an issue price
Y4 PV
of R100 each. Company X has just paid the most
0 0 Year 1 PV of the
recently due preference dividend, and has dividend + future
announced that financially difficult times are ahead. year 2 dividends
It is expected that the dividend for the next two dividend +
years will be passed. Thereafter, normal dividend Year 3
dividend
payments are expected to be resumed. The
preference dividend is 12% and required return is 0 0 12+12+12 12/14%iv
=36 = 85.71
14%. Calculate the value of each preference share
today
Value of Preference shares at Y3= 36 + 85.71
Value of Preference shares at Y3= 121.71
PV of preference shares = 121.71/ (1+ 0.14)^3 (don’t need to show this step)
Total
(not per share) PV of preference shares = 82.15
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Preference shares
Non‐Cumulative Irredeemable Preference Shares
Yo Y1 Y2 Y3 Y4
How would this change if the preference shares
were not cumulative? Y4 PV
0 0 12 PV of the
future
dividends

0 0 12 12/14%iv
= 85.71

Value of Preference shares at Y3= 12 + 85.71

Value of Preference shares at Y3= 97.71
Total
PV of preference shares = 97.71/ (1+ 0.14)^3 (don’t need to show this step)
(not per share) PV of preference shares = 65.95
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Equity
The concepts applied to value equity are the same as those applied to value debt and preference shares.

• Given Market information

• Use ratios to calculate share value
• Dividends
• Constant dividend into perpetuity
• Constant dividend growth (Dividend growth model)
• Two stage dividend growth
Constant Dividend

• Equity has no maturity

• PV= Dividend/ ke
• If dividend per share is R0.80 and the Cost of Equity is 11%
Market value per share is 0.80/.11 = R7.27 per share
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Equity
Constant dividend growth (Dividend growth model)

𝑃𝑉 = 𝐷0 (1 + 𝑔)/(𝑘𝑒 − 𝑔)

𝐷0 (1 + 𝑔) = next year’s dividend

𝑘𝑒 = cost of equity
𝑔 = future constant growth rate in earnings/dividends

Example
ABC Limited is a pharmaceutical company and has just paid a dividend of 20 cents per share. Its shareholders require a
return of 12% per year. ABC expects to grow its dividend by 6% per year indefinitely into the future. What is the value of
each ordinary share in ABC?

The current dividend (D0) 0.20 Value = D0(1+g)/(k‐g)

Constant growth rate 6% Value = 0.20x(1.06)/(0.12‐0.06)
Required return 12% Value = 3.53 per share
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Equity
Constant dividend growth (Dividend growth model) cont.

If dividend growth not provided then:

• Growth in dividends over the long term should reflect earnings growth.

• Sustainable growth rate

RoE x Retention ratio (“RR”) = RoE x (1‐(DPS/EPS))
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Equity
Two stage dividend growth

What will happen to the value of each share in ABC if the company is able to grow its current dividend of 20 cents per share
by 20% per year for the next three years, and thereafter growth is expected to be 5% per year. Assume cost of equity is
12%?
5% growth pa

Yo Y1 Y2 Y3 Y4
0.24 0.29 0.35
Calculations:
The current dividend in 0.20
Therefore the dividend in year 1: 0.20 x 1.20 = 0.24
The dividend in year 2: 0.24 x 1.20 = 0.29
The dividend in year 3: 0.29 x 1.20 = 0.35
Year 4:
PV0 = D0(1+g)/(k‐g)
PV3 = D3(1+g)/(k‐g)
Ye = 0.35(1+5%)/(12%‐5%)
Year = 5.25
 STEP 2a‐ CALCULATE MARKET VALUE PER
COMPONENT cont.
Market value: Equity
Two stage dividend growth cont.
5% growth pa

Y0 Y1 Y2 Y3 Y4 Calculator inputs?
0.24 0.29 0.35
5.25

Y4 PV

Y0 Y1 Y2 Y3
0.24 0.29 5.60
PV= R 4.43
 APPROACHING A WACC CALCULATION

Step 1 Step 2a Step 2b Step 3 Step 4

Capital Market value Cost/ return Weighting Weigthed return

Market
Permanent
value

Total MV WACC
Step 5
 APPROACHING A WACC CALCULATION

Step 1 Step 2a Step 2b Step 3 Step 4

Capital Market value Cost/ return Weighting Weigthed return
Share Capital Market info, ratio analysis,
future dividends
Retained Earnings Accounting Adjustment
Non‐redeemable
Perpetuity PV= Div/ Kp
preference shares
Redeemable PV/ Cash flow function
preference shares on calculator

8% Debentures PV/ Cash flow function on calc

Deferred tax Accounting Adjustment
Accounts payable Short term
Overdraft facility Management intention

Total MV WACC
Step 5
 STEP 2b‐ CALCULATE COST/ RETURN PER
COMPONENT
Cost of preference shares (Kp)
• Kp= is the current market required return Solution:
• No adjustment for tax
Cost / return
Example: A Ltd has 12% Non‐redeemable Preference Kp= 10%
shares (R 150 par value each). These shares were issued
12 years ago at a premium of 8%. This resulted in a Market value
yield to maturity at the time of 11%. The book value of Par value (1+0.08)=32.4 million
R32.4 million as reflected in the financial statements at Therefore Par value = 30 million
31 January 2025 (today’s date) is the par value plus
premium of the shares. The current market related rate MV= Dividend / Kp
for similar preference shares is 10%. Dividends are paid Dividend = 30 million * 12%
on the 31 January each year. Dividend = 3.6 million

Question: Determine the value of these preference MV= Dividend / Kp

shares as well as the cost for purposes of calculating MV= 3.6 million/10%
the WACC of A Ltd at 31 January 2025. MV= 36 million
 STEP 2b‐ CALCULATE COST/ RETURN PER
COMPONENT
Cost of debt (Kd)
• Kd= is the current market required return for debt of Example 2:
similar risk Assume that the price of a bond is currently trading at
• After tax R93.80. The bond has a face value of R100. The coupon
rate is 10% and the redemption date is in 5 years’ time.
Example 1: Co A wishes to borrow R10m from its bank Calculate the cost of debt.
repayable in 7 years’ time. The bank’s lending rate is
15%. The company tax rate is 27%. What is the cost of Solution:
the debt to the company? PV= 93.8
PMT= 100*10%= ‐10
Solution: N= 5
Kd= 15% (1‐27%) FV= ‐100
Kd= 10.95% i= SOLVE

i= 11.707%
Kd= 11.707 *(1‐27%)
Kd= 8.55%
 STEP 2b‐ CALCULATE COST/ RETURN PER
COMPONENT
Cost of debt (Kd)
Example 3: AB Ltd has 14% Bonds with a book value of Solution:
R50 million (nominal value of R 50 per instrument). The PV= 60
current market price is R 60, the interest payments on PMT= 50*14%= ‐7
bonds are made on 31 December annually. The bonds N=2
will be redeemed on 31 December 2026 at a premium FV= ‐50*(1+15%)=57.50
of 15% on the nominal value. After their redemption rate= SOLVE
the bonds will be replaced with similar instruments.
The current date is 31 December 2024. rate= 9.68%
Kd= 9.68 *(1‐27%)
Question: Determine the value of these bonds, as well Kd= 7.07%
as their cost, for the purpose of calculating the WACC
of AB Ltd at 31 December 2024. Total value = market price * number of shares
Number of shares = 50 million/ 50 (price per share)
Number of shares = 1 million

Total market value = 1 million * R60

Total market value = 60 million
 STEP 2b‐ CALCULATE COST/ RETURN PER
COMPONENT
Cost of debt (Kd)
Example 4: AB Ltd has 14% semi‐annual bonds with a Cum‐interest:
book value of R50 million (nominal value of R 50 per
Interest = 3.5 Interest = 3.5
instrument). The current cum‐interest market price is
R63.50, the interest payments on bonds are made on
30 June and 31 December annually. The bonds will be
redeemed on 30 June 2026 at a premium of 15% on the
nominal value. After their redemption the bonds will be
replaced with similar instruments. The current date is R50 par 50*14%/2 R63.50 cum interest
31 December 2024. 31 Dec 2023 =3.5 31 Dec 2024
30 June 2024
Question: Determine the value of these bonds, as well Total value = market price * number of shares
as their cost, for the purpose of calculating the WACC Number of shares = 50 million/ 50 (price per share)
of AB Ltd at 31 December 2024. Number of shares = 1 million

Total market value = 1 million * (R63.5‐3.5)

Total market value = 60 million
 STEP 2b‐ CALCULATE COST/ RETURN PER
COMPONENT
Cost of debt (Kd)
Kd: Kd:
PV= 60 Cash flow function
PMT= 50*14%= ‐7 IRR= 2.88%
Example 3 Example 4
N=2 (semi‐annual rate)
FV= ‐50*(1+15%)=57.50
rate= SOLVE Kd= 5.84
(effective annual rate) Not adjusted for
tax

31 Dec 2024 30 June 2025 30 Dec 2025 30 June 2026 30 Dec 2026
PV 60 million 50*14%/2 =‐3.5mil 50*14%/2 =‐3.5 million 50*14%/2 =‐3.5mil Annual tax = 3.5 mil *27%
Annual tax = 7 mil *27% Redeemed ‐57.5 million =0.945 million
=1.89 million

Therefore net cash flow= Therefore net cash

‐1.61 million flow= ‐61 million
 STEP 2b‐ CALCULATE COST/ RETURN PER
COMPONENT
Cost of equity (Ke)
• Ke= a shareholder's required rate of return on an Dividend growth model:
equity investment. It is the rate of return that could
have been earned by putting the same money into a 𝑃V (P0) = 𝐷0 (1 + 𝑔)/(𝑘𝑒 − 𝑔)
different investment with equal risk
Ke= D1/P0 + g
• Three approaches to determine Ke
a) Dividend growth Model Bond yield plus risk premium
b) Bond Yield Plus a Risk Premium Ke= Kd+ a premium
c) CAPM
CAPM Beta based on change in shares
𝐾𝑒 = 𝑅𝑓 + 𝛽 (𝑅𝑚 − 𝑅𝑓) relative to market (not industry)

MRP/ERP
Long term
5year, 10 year, 15 years, 20 year?
 STEP 2b‐ CALCULATE COST/ RETURN PER
COMPONENT
Cost of equity (Ke)
Example: Dividend
AB Ltd.’s ordinary shares are currently (31 December EPS 2024 (given) 16.00
2024) trading at R 149 cum‐div per share. The dividend Payout ratio (given) 25%
for the 2024 year will be paid today. These shares were Therefore 2024 Dividend 4
issued many years ago when the company listed on the
JSE at par of R75 per share and are reflected at a book Market value per share= 149‐4 = 145
value of R375 million in the financials. The company Number of shares= 375,000,000 / 75
has a historic dividend pay‐out ratio of 25%, and Total market value= 145* (375,000,000 / 75)
intends that this policy will continue into the Total market value= 725 000 000
foreseeable future. AB ltd ROE is 10.32%. AB Ltd
achieved an EPS of R16 for 2024. ke = D1 / Po + G D1= 4(1+0.0774)
Do= 4 D1= 4.31
Questions: D1= 4(1+g)
Determine the value of the equity as well as the cost Ke= 4.31/145 +7.74%
for purposes of calculating the WACC of A Ltd at 31 SGR= ROE * RR Ke= 10.71%
December 2024 SGR= 10.32%*(1‐0.25)
SGR= 7.74%
 APPROACHING A WACC CALCULATION

Step 1 Step 2a Step 2b Step 3 Step 4

Capital Market value Cost/ return Weighting Weigthed return
Share Capital Market info, ratio analysis, Ke: Div growth model,
future dividends Bond Yield + premium,
Retained Earnings Accounting Adjustment CAPM
Non‐redeemable
Perpetuity PV= Div/ Kp Kp
preference shares
Redeemable PV/ Cash flow function Kp
preference shares on calculator

8% Debentures PV/ Cash flow function on calc Kd (1‐ tax rate)

Deferred tax Accounting Adjustment

Accounts payable Short term
Overdraft facility Management intention Kd (1‐ tax rate)

Total MV WACC
Step 5
WACC FORMULA
 STEP 3‐ WEIGHTING

Step 1 Step 2a Step 2b Step 3 Step 4

Capital Market value Cost/ return Weighting Weigthed return
Share Capital 725 000 000 10.71% 725 000 000/821 000 000
=88.31%
Retained Earnings Accounting Adjustment
Non‐redeemable
preference shares 36 000 000 10.00% 36 000 000/821 000 000
=4.38%
Redeemable
Short term
preference shares
60 000 000 5.84% 60 000 000/821 000 000
8% Debentures =7.31%
Deferred tax Accounting Adjustment
Accounts payable Short term
Overdraft facility Short term

Total
821 000 MV
000 WACC
Step 5
 STEP 4‐ WEIGHTED RETURN

Step 1 Step 2a Step 2b Step 3 Step 4

Capital Market value Cost/ return Weighting Weigthed return
Share Capital 725 000 000 10.71% 725 000 000/821 000 000 10.71* 88.31%
=88.31% =9.46%
Retained Earnings Accounting Adjustment
Non‐redeemable
preference shares 36 000 000 10.00% 36 000 000/821 000 000 10%* 4.38%
=4.38% =0.44%
Redeemable
Short term
preference shares
60 000 000 5.84% 60 000 000/821 000 000 5.84%* 7.31%
8% Debentures =7.31% =0.4%
Deferred tax Accounting Adjustment
Accounts payable Short term
Overdraft facility Short term

Total
821 000 MV
000 WACC
Step 5
 STEP 5‐ WACC

Step 1 Step 2a Step 2b Step 3 Step 4

Capital Market value Cost/ return Weighting Weigthed return
Share Capital 725 000 000 10.71% 725 000 000/821 000 000 10.71* 88.31%
=88.31% =9.46%
Retained Earnings Accounting Adjustment
Non‐redeemable
preference shares 36 000 000 10.00% 36 000 000/821 000 000 10%* 4.38%
=4.38% =0.44%
Redeemable
Short term
preference shares
60 000 000 5.84% 60 000 000/821 000 000 5.84%* 7.31%
8% Debentures =7.31% =0.4%
Deferred tax Accounting Adjustment
Accounts payable Short term
Overdraft facility Short term

Total
821 000 MV
000 WACC
10.33%

Step 5
Additional factors to consider

Shortfall (WACC, CoE)

Project & company specific

Comp maths principles