When calculating the WACC why do we mutliply equity/total with the cost of equity and debt/total with the cost of debt. I think this might just be purely mathematical and not related to financial management as it just involves calculating a weighted average but I am just a little confused.

Why are you confused? We need to know the overall cost of capital – some comes from equity and some comes from debt and therefore we calculate the average.

As I say in the lecture, the reasoning for using the WACC (and when not to use the WACC) is covered in the subsequent lectures.

Urgent Help !! You have said that in irredeemable we only take account of tax but not in redeemable debts but in Example 10 in cost of debt calculation. Year 1-6 Int (10 * 0.70) = 7p.a ?? Why have you used tax as it’s redeemable debt.
In last lecture example 8 with redeemable debt you didn’t take into account tax
1-5 int 6pa .
Why is is different ??

You have misunderstood – we always take account of tax whether it is redeemable or irredeemable, if we are calculating the cost of debt to the company.

If we are looking at the return to investors, then we ignore tax (whether redeemable or irredeemable) because company tax does not affect them.

What I said was that it it is irredeemable, then the cost to the company is the return to investors multiplied by (1 -t).

If it is redeemable then that does not work, and to get the cost to the company we have to calculate the IRR of the flows using the after-tax interest (but the repayment at the end is not tax allowable).

Thanks John for this good work.
Now I have got a problem,could you kindly explain to me the differences between these words because im totally lost; ex int, ex div, cum div and cum int.
I totally get lost when you start talking about these words.
Thanks again.

I have one question suppose a company XYZ Ltd has cost of debt & preference shares @ 8% and equity shares of face value Rs 10 each which will be issued at a premium of Rs 10 each and also the Co. is having a requirement to raise Rs 200,000, the expected EBIT of the Co. is Rs80,000.The tax rate is 50%; what will be the Co’s EPS, the financial break level and indifference level of EBIT.

You must ask this in the F9 Ask the Tutor Forum, not as a comment on a lecture. (although neither ‘financial break level’ nor ‘indifference level’ can be asked in Paper F9.

Dear Sir,
I have a different kind of question.can you just please help me to solve the following question.

Assume that ABC Corporation has the following capital structure. 30% debt, 10% preferred stock, & 60% equity. ABC Corporation wishes to maintain these proportions as it raises new funds.it’s before tax cost of debt is 8%, it’s cost of preferred stock is 10%, & it’s cost of equity is 15%. if the company’s marginal tax rate is 40%. what is ABC’s WACC?

hi! sir could please explain here the concept of perpetuity..i was trying to attept a question relating cost of capital and i could not find the correct answer.here is the qustion:
Q: Z has 10,000 shares in issue, dividends for the next five years are expected to be
constant at 10 cents per share and then grow at 5% per year to perpetuity; cost of
equity 15%. CALCULATE MARKET VALUE?

I assume that you have watched the free lecture on the valuation of securities. In which case you will know that the market value of a share is the present value of the future expected dividends.
In this question, you can calculate the present value of the first 5 years of dividends by discounting the 10c a share using the annuity factor for 5 years at 15%.

Once you get to the perpetuity (which is from year 6 to infinity) you use the first formula on the formula sheet. However, this formula gives the present value now assuming that the first dividend is in 1 years time. In this question the perpetuity starts 5 years late (it starts at time 6 instead of time 1) and therefore you have to discount the result from the formula for 5 years at 15% to get the present value.

Finally, if you add the result of the previous paragraph to the result from the paragraph before, you will have the market value of the share – the present value of all the future dividends.

(If you have not watched the lecture on the valuation of securities then do, because this question in itself has nothing to do with the WACC, which is what the lecture above is about.)

hello sir,please i need a little clarification on the tax rate for redeemable and irredeemable debt. from my own understanding(i might be wrong) we are still deducting tax of 30%. my question is how do we save on tax with irredeemable debt and not save tax on redeembale but yet we still deduct 30%..i think i am confused and have it all mixed up.
As usual thanks for the great lectures.

We save tax on both redeemable and irredeemable. However in both cases we only save tax on the interest payments. With redeemable debt there is also the repayment, but we do not save tax on the repayment – only on the interest each year.

Hello Sir, Just wanna ask one thing while calculating cost of debt, you have assumed the interest to be 7 p.a. shouldn’t it be 10? because in example 8, while calculating the same thing you have ignored tax. I’m abit confused where we should ignore tax and where we should consider it. Waiting for your answer.
Thanking you in anticipation.
Rehan 🙂

I think you must have skipped through the lecture too quickly (or else you have not downloaded the course notes, which makes the lecture impossible!).

When we are calculating the return to the investor then tax is not relevant – they investor receives the full interest.

When we are calculating the cost to the company then tax is relevant – the company gets tax relief on the interest which makes the net cost lower.

I assume that you have downloaded the Course Notes (otherwise it is pointless watching the lectures 🙂 ) in which case you will see that the requirements for both examples are (a) calculate the return to investors, and (b) calculate the cost of debt to the company.

Yeah John! I remember waac formulae was at 2 places in investment appraisal questions. 1 was just easy formuale, the other time it was added with capm( project-specific cost)…!

Not quite. There is only one way of calculating the WACC.
The calculation of the cost of equity can be in two ways – using the dividend growth model or using the capital asset pricing model (depending on the information given) – both are covered in our Course Notes and lectures.

In example 10 of chapter 17 of OT notes – IRR= 5%+12.59/25.06*5%
I’m bit confused because we first discounted at10% and then we guessed d.f @ 5% because of negative NPV at 10%, comparing this against example 8 shouldn’t IRR be 10%+12.59/25.06*5%

I’m not sure why you’ve used 5% instead of 10%. Please explain

You just make things so simple that i now have confidence in mastering this subject. I like it when, in your humour, you pick on Peter, Valentino, Andrea and ‘Hello, Hello’ for lagging in their attention (smiling…) Your lectures are just soooo joyful and beneficial to hear and watch.

You are indeed a gem and a great asset to producing future generations of capable accountants!
Please continue with your antics and style of lecturing. They are very effective and I just love them…..

It depends whether or not the overdraft is intended to be long term.

If not long term then it should not be included.

If it is intended to be long term then it should be included (remembering that the cost is the interest less tax relief).

Usually the examiner makes it clear as to whether or not it is intended to be long term. If he does not make it clear then he accepts it included or not included (even though the WACC may be different). Just check as to whether or not he make it clear, and if he does not then state your assumption.

Honestly, what is it with tutors on opentuition (John Moffat especially) that once they handle topics on ACCA, cloudy areas just become clear and dreaded subject areas become a piece of cake? They just ace it when they explain topics… Really, other tutors (who think they know stuff but don’t) should learn from these great OT tutors…they’re simply awesome! Common guys we need to canvass for an award for ’em..Not being patronising, just truly grateful 🙂

Hi, the lectures are very good. But on this example i am having problems understanding two calculations.
Can someone please explain why the interest on the cost of Debt calculation is (10×0.7)?. I thought that since there are 10% debentures it should have been (10×0.10)?
Also, on the WACC calculation the MV of Debt is 6.3M, why?
thank you!

@superacca, The interest on 100 nominal is 10 per year, but it is tax allowable at 30% and so the after tax cost to the company is only 70% x 10 = 7 per year.

The question says that the debentures are quoted at 105 (which means 105 per 100 nominal). So given there are $6M nominal, the market value is $6 x 105/100 = $6.3M

@johnmoffat,
Thank you for the explanation. It makes sense now and was also computed on previous examples, my bad i missed it…..You are a great lecturer and to be honest, its the first time i enjoy watching acca lectures. You also made me laugh at some videos with your comments 🙂
Thank you soooo much, i will definately pass with your help!

@cammielot, The WACC is the overall cost of the finance used in the company.
The return on assets is an accounting measure and is the profit as a percentage of the total capital (usually at balance sheet value).

An excellent lecture.This lecture explains maybe why some students fail the f9 examination.Because if one relies on the formula used for calculating the WACC and the question deals with redeemable debt one will fail that part of the question and this means losing valuable marks

Arun says

Hi John,

When calculating the WACC why do we mutliply equity/total with the cost of equity and debt/total with the cost of debt. I think this might just be purely mathematical and not related to financial management as it just involves calculating a weighted average but I am just a little confused.

Thanks.

John Moffat says

Why are you confused? We need to know the overall cost of capital – some comes from equity and some comes from debt and therefore we calculate the average.

As I say in the lecture, the reasoning for using the WACC (and when not to use the WACC) is covered in the subsequent lectures.

Ashley R says

HAHAH!!Best Part….The examiner himself ignores the formula :p ….he is jst St.. you never ever evr….THANKS JOHN….!!!your lectures are the best ^__^

John Moffat says

Thank you 🙂

rajaasifahmed says

Urgent Help !! You have said that in irredeemable we only take account of tax but not in redeemable debts but in Example 10 in cost of debt calculation. Year 1-6 Int (10 * 0.70) = 7p.a ?? Why have you used tax as it’s redeemable debt.

In last lecture example 8 with redeemable debt you didn’t take into account tax

1-5 int 6pa .

Why is is different ??

rajaasifahmed says

In notes example 8 & 10 they have taken into account of tax in case of redeemable debt???

John Moffat says

You have misunderstood – we always take account of tax whether it is redeemable or irredeemable, if we are calculating the cost of debt to the company.

If we are looking at the return to investors, then we ignore tax (whether redeemable or irredeemable) because company tax does not affect them.

What I said was that it it is irredeemable, then the cost to the company is the return to investors multiplied by (1 -t).

If it is redeemable then that does not work, and to get the cost to the company we have to calculate the IRR of the flows using the after-tax interest (but the repayment at the end is not tax allowable).

rajaasifahmed says

I really appreciate your prompt response. Now I have fully understood . Many many thanks Sir !!!!

brenda1 says

Thanks so much John!!!

brenda1 says

halo sir,for chapter 17,example 10, where do we get the 32M and 6.3M when calculating the WACC.

John Moffat says

They are the market values of equity (10M shares x $3.20) and of debt ($6M x 105/100)

brenda1 says

Thanks John for this good work.

Now I have got a problem,could you kindly explain to me the differences between these words because im totally lost; ex int, ex div, cum div and cum int.

I totally get lost when you start talking about these words.

Thanks again.

John Moffat says

ex int and ex div are the market values of debt and of equity assuming that interest and dividends have just been paid.

cum int and cum div are the market values assuming that interest and dividend are about to be paid.

The cum values are the ex values plus the interest or dividend about to be paid.

In the exam, values are always ex div and ex int unless told differently.

deepa says

Sir/Madam,

I have one question suppose a company XYZ Ltd has cost of debt & preference shares @ 8% and equity shares of face value Rs 10 each which will be issued at a premium of Rs 10 each and also the Co. is having a requirement to raise Rs 200,000, the expected EBIT of the Co. is Rs80,000.The tax rate is 50%; what will be the Co’s EPS, the financial break level and indifference level of EBIT.

John Moffat says

You must ask this in the F9 Ask the Tutor Forum, not as a comment on a lecture. (although neither ‘financial break level’ nor ‘indifference level’ can be asked in Paper F9.

randolph123 says

Dear Sir,

I have a different kind of question.can you just please help me to solve the following question.

Assume that ABC Corporation has the following capital structure. 30% debt, 10% preferred stock, & 60% equity. ABC Corporation wishes to maintain these proportions as it raises new funds.it’s before tax cost of debt is 8%, it’s cost of preferred stock is 10%, & it’s cost of equity is 15%. if the company’s marginal tax rate is 40%. what is ABC’s WACC?

Thanks Sir

Randolph

John Moffat says

The cost of debt is 8% x (1-0.4) = 4.8%

The cost of preference shares is 10%

The cost of equity if 15%

To get the WACC you multiply each cost by the proportions (30%; 10% and 60%) and add them up.

I do suggest that you watch the free lectures on WACC.

jia says

hi! sir could please explain here the concept of perpetuity..i was trying to attept a question relating cost of capital and i could not find the correct answer.here is the qustion:

Q: Z has 10,000 shares in issue, dividends for the next five years are expected to be

constant at 10 cents per share and then grow at 5% per year to perpetuity; cost of

equity 15%. CALCULATE MARKET VALUE?

John Moffat says

Perpetuity means for ever.

I assume that you have watched the free lecture on the valuation of securities. In which case you will know that the market value of a share is the present value of the future expected dividends.

In this question, you can calculate the present value of the first 5 years of dividends by discounting the 10c a share using the annuity factor for 5 years at 15%.

Once you get to the perpetuity (which is from year 6 to infinity) you use the first formula on the formula sheet. However, this formula gives the present value now assuming that the first dividend is in 1 years time. In this question the perpetuity starts 5 years late (it starts at time 6 instead of time 1) and therefore you have to discount the result from the formula for 5 years at 15% to get the present value.

Finally, if you add the result of the previous paragraph to the result from the paragraph before, you will have the market value of the share – the present value of all the future dividends.

(If you have not watched the lecture on the valuation of securities then do, because this question in itself has nothing to do with the WACC, which is what the lecture above is about.)

jia says

That i’ll do.thank you so much! i got the answer.

yetunde says

hello sir,please i need a little clarification on the tax rate for redeemable and irredeemable debt. from my own understanding(i might be wrong) we are still deducting tax of 30%. my question is how do we save on tax with irredeemable debt and not save tax on redeembale but yet we still deduct 30%..i think i am confused and have it all mixed up.

As usual thanks for the great lectures.

John Moffat says

We save tax on both redeemable and irredeemable. However in both cases we only save tax on the interest payments. With redeemable debt there is also the repayment, but we do not save tax on the repayment – only on the interest each year.

yetunde says

thank you sir for the swift response and its clearer now,

rehan1o1 says

Hello Sir, Just wanna ask one thing while calculating cost of debt, you have assumed the interest to be 7 p.a. shouldn’t it be 10? because in example 8, while calculating the same thing you have ignored tax. I’m abit confused where we should ignore tax and where we should consider it. Waiting for your answer.

Thanking you in anticipation.

Rehan 🙂

John Moffat says

I think you must have skipped through the lecture too quickly (or else you have not downloaded the course notes, which makes the lecture impossible!).

When we are calculating the return to the investor then tax is not relevant – they investor receives the full interest.

When we are calculating the cost to the company then tax is relevant – the company gets tax relief on the interest which makes the net cost lower.

I assume that you have downloaded the Course Notes (otherwise it is pointless watching the lectures 🙂 ) in which case you will see that the requirements for both examples are (a) calculate the return to investors, and (b) calculate the cost of debt to the company.

I have done the same thing in both examples.

acca2050 says

Yeah John! I remember waac formulae was at 2 places in investment appraisal questions. 1 was just easy formuale, the other time it was added with capm( project-specific cost)…!

John Moffat says

Not quite. There is only one way of calculating the WACC.

The calculation of the cost of equity can be in two ways – using the dividend growth model or using the capital asset pricing model (depending on the information given) – both are covered in our Course Notes and lectures.

iluvgorgeous says

thank you so much

sandra1964 says

Thanks so much John you are a gem

iluvgorgeous says

example 10 on wacc- how is Debt market value worked out to be 6.3? sorry

John Moffat says

The nominal value of the debentures is $6M.

The market value is 105 (which means $105 for every $100 nominal).

So the total market value is $6M x 105/100 = $6.3M

Amon says

Dear John,

In example 10 of chapter 17 of OT notes – IRR= 5%+12.59/25.06*5%

I’m bit confused because we first discounted at10% and then we guessed d.f @ 5% because of negative NPV at 10%, comparing this against example 8 shouldn’t IRR be 10%+12.59/25.06*5%

I’m not sure why you’ve used 5% instead of 10%. Please explain

Looking forward to your reply.

Thanks

Castrin

Amon says

Apologies, it’s quite straight forward, I understand it perfectly now.

M Fauzi says

Dear Sir John Moffart,

You just make things so simple that i now have confidence in mastering this subject. I like it when, in your humour, you pick on Peter, Valentino, Andrea and ‘Hello, Hello’ for lagging in their attention (smiling…) Your lectures are just soooo joyful and beneficial to hear and watch.

You are indeed a gem and a great asset to producing future generations of capable accountants!

Please continue with your antics and style of lecturing. They are very effective and I just love them…..

eadinnu says

Dear prof,

What you have done on WACC is to demystify a dreaded masquerade.

OT is the best! I am not only confident that I will pass F9, but will make a good grade.

Thanks a lot.

zee90 says

5% Preference shares ($1 nominal value) 10

the ex-dividend market value of the preference

shares is $6·25 million

what will be the cost of preference shares ????????

thank you

zee90 says

can we use overdraft in wacc ?

e.g 5% overdraft is given in question ?

John Moffat says

It depends whether or not the overdraft is intended to be long term.

If not long term then it should not be included.

If it is intended to be long term then it should be included (remembering that the cost is the interest less tax relief).

Usually the examiner makes it clear as to whether or not it is intended to be long term. If he does not make it clear then he accepts it included or not included (even though the WACC may be different). Just check as to whether or not he make it clear, and if he does not then state your assumption.

Tharua ( ਠਰੂਆ ) says

thanks ,, its priceless .

shehzaad says

Dear John, ur GENIUS! THX LOAAAADDZZZZ

manonaseriousmission says

Honestly, what is it with tutors on opentuition (John Moffat especially) that once they handle topics on ACCA, cloudy areas just become clear and dreaded subject areas become a piece of cake? They just ace it when they explain topics… Really, other tutors (who think they know stuff but don’t) should learn from these great OT tutors…they’re simply awesome! Common guys we need to canvass for an award for ’em..Not being patronising, just truly grateful 🙂

ai1989 says

sublime.

sheffernb says

I WAS SO SCARED OF WACC UNTIL I SAW MR MOFFATS EXPLATION ..THANK YOU SIR

titioluwa says

Thank you so much. I used to be scared when I see questions on WACC. It is actually so straight forward and interesting!

janesharmila says

Strange, but the lecture stopped after example 9.( just 5 minutes)

Could you pls see if something is wrong?

Thank you

npoku says

Thank you for letting us know about the WACC formula. your working makes it very easy now.

kahsay12 says

wow fantastic thank you

superacca says

Hi, the lectures are very good. But on this example i am having problems understanding two calculations.

Can someone please explain why the interest on the cost of Debt calculation is (10×0.7)?. I thought that since there are 10% debentures it should have been (10×0.10)?

Also, on the WACC calculation the MV of Debt is 6.3M, why?

thank you!

John Moffat says

@superacca, The interest on 100 nominal is 10 per year, but it is tax allowable at 30% and so the after tax cost to the company is only 70% x 10 = 7 per year.

The question says that the debentures are quoted at 105 (which means 105 per 100 nominal). So given there are $6M nominal, the market value is $6 x 105/100 = $6.3M

superacca says

@johnmoffat,

Thank you for the explanation. It makes sense now and was also computed on previous examples, my bad i missed it…..You are a great lecturer and to be honest, its the first time i enjoy watching acca lectures. You also made me laugh at some videos with your comments 🙂

Thank you soooo much, i will definately pass with your help!

tandi says

So relieved someone has asked this. I have been wrecking my brain trying to figure out where $6.3m came from. Pheew!! Makes sense. Thank you.

kayez1234 says

Very nice lecture, real eye opener!!

maggs says

keep up the good work, well explained, with these lectures and my hard work i dont see myself failing, sereously…!!!

cammielot says

What is the difference between the WACC and the return on assets?

John Moffat says

@cammielot, The WACC is the overall cost of the finance used in the company.

The return on assets is an accounting measure and is the profit as a percentage of the total capital (usually at balance sheet value).

bhavnamehta17 says

Nicely explained, thank you, I like the way he makes complicated things easy.

foster says

An excellent lecture.This lecture explains maybe why some students fail the f9 examination.Because if one relies on the formula used for calculating the WACC and the question deals with redeemable debt one will fail that part of the question and this means losing valuable marks

Ammar.Shabbir says

John Moffat hats off to u… U R A GRT8 TEACHER MAY GOD BLESS U……

Saad Bin Aziz says

ALL F9 LECTURES ARE TERRIFIC! THANK YOU OPEN TUITION OR SHOULD I SAY “SHUKRIYA” AS WE SAY IT IN URDU LANGUAGE:-)

panayiotis2002 says

i strongly agree

tabibatlokwa says

These lectures are just so priceless…..!!!

He just makes everything so easy to understand….