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I am having a little trouble calculating WACC. I am using the formula (%e x Ke) +(% d x Ke x (1- tax rate)
However i a working out June 2014 past papers, Question 1:
Cost of equity 15.7%
Tax rate 25%
Pre- tax cost of debt 6.5%
I don’t understand why the examiner sets out the working as (1/1/3 x 15.7%) + ( 0.3/ 1.3 x 6.5% x (1-25%)
help me clarify please. I understand every thing else, except for 1/ 1/3 & 0.3 x 1.3). Please reply quickly.
Firstly there seems to be a typo in the expression (1/1/3), which I believe should be (1/1.3)
In WACC calculation, the cost of equity or Ke has to be weighted based on the ratio of equity to (equity + debt) and cost of debt or Kd (post tax) based on the ratio of debt to (equity + debt) before adding both %s together. This will look like as follows:
WACC = [ (Ve/(Ve+Vd) X Ke ] + [ (Vd/(Ve+Vd) X Kd (1-T) ]
In your question,
Debt to Equity, given is 30% or 30/100 based on which:
Ve = 100 or 1
Vd = 30 or 0.3
Ve+Vd = 130 or 1.3
Post tax Kd = 6.5% X (1-0.25)
Ke = 15.7%
Applying the above formula,
WACC = [ (1 / 1.3 X 15.7% ) + (0.3 / 1.3 x (6.5% x 0.75) ]
WACC = 13.2%
Answering your question..
As you may notice in the above formula and the application, [1 / 1.3] is actually the ratio of Equity (100% or 1) to Equity + Debt (100% + 30% or 1.3). Where as [0.3 / 1.3] is actually the ratio of debt (30% or 0.3) to Equity + Debt (100% + 30% or 1.3).
Thanks a million for the clarification. I really appreciate your response.