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.)

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.