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The weighted average cost of capital (WACC) – ACCA Financial Management (FM)

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  1. Hi Im a bit confused about the incorporation of the tax elements
    In example 9 you mentioned that there was no indication of the debt being redeemable, so it is assumed its an irredeemable debt. Hence the formula I(1-T)/MV

    In example 10, the debt was a redeemable debt yet you still incorporated the tax element.

    Is there any reason for this? or kindly clarify

    Thanks

    • We always incorporate the tax saving in the calculation of the cost of debt.

      With redeemable debt we take the IRR of the after tax flows. With irredeemable debt we take the after tax interest dividend by the market value.

  3. There is a formula to calculate cost of redeemable debt
    =(I*(1-T)+[{RV-MV}/N]) / [(RV+MV)/2)]
    I = Interest
    T = tax rate
    RV = redemption value
    MV = market value
    N = Number of years till redemption

    Can we use this in exam rather than calculating IRR?

  4. In question 9 Part a question is asking to calculate Return to INVESTORS on Debt. so why are we taking tax into account for the same ?

    We generally take tax into account when we calculate cost of capital for company. Right ?

    • Using those two guesses does indeed give an IRR of 6.63%, but as I state in the lectures different guesses will give different answers because the relationship is not linear.

      However, they were rather extreme guesses to have used (which is why your answer is so much different). As a very rough guide, always divide the after-tax interest by the market value. For this question it gives 7/105 = 6.67%. The actual IRR will be little bit higher because the redemption is at a premium, but there is no way it is going to be as high as 15% 馃檪

      • Hi teacher, I used 5% and 10% then I have the same result like yours (7.51%) but when I used 10% and 15% as the friend above, but my result is [10% + (12.47 / 18.52)* 5% ] = 13.36%
        Please advise! Thank you!!!

      • The NPV’s at 10% and 15% are both negative, so the IRR cannot possibly be more than 10% !!!

        The IRR = 10% – (12.47/18,52 x 5%) = 6.63%

  7. Hi there John,

    In example 10 I tried this by myself and instead of using 5 and 10% to calculate the cost of debt, I used 5 and 8%. This gave me the answer, 8.02%. Have I done something wrong or should I stick to multiples of 5 or something?

    Kind regards

      • I think you mean differences in the cost of debt (not the cost of equity).

        The answer (and I do say this in my lectures) is that the estimate of the cost of debt can certainly differ by that much, because the relationship between the rate of interest and the NPV is not linear. If it is were than 1% different, then it almost certainly means that you would have made a mistake.

  8. I’m a bit confused. During calculations of WACC, you can use both book value and market value. It is obvious that the book value will differ from the market one. In the video, the market values of equity and debt are used in WACC calculation. Which approach should be used during the exam?

    Thank you in advance!

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