We need to know what it costs us to put our money to work, i.e. we need to find out our cost of capital. The steps to calculate the cost of capital are as follows:
- Calculate the cost of debt, which includes calculating the asset beta, debt beta, the risk free rate of interest and the cost of debt. We will cover calculating asset and debt beta in later courses, which is why it hasn’t been discussed here. In this course we will work with risk free rate of interest and the cost of capital.
- Calculate the Cost of Equity. This requires determining values for equity beta, the risk premium and the risk free rate of interest.
- Upon calculating the cost of equity, the cost of debt and the capital structure, you will be ready to calculate the cost of capital
You may be wondering where to find a business’ beta. Well, you can look in published beta books that list betas for a number of companies or you can just go to www.quicken.com for a close approximation of the beta for a business.
The risk free rate of return is different for 1-year, 10-year and 30-year bonds. But just to make it easier, we will use the rate for a 30-year bond.
The risk premium varies between 5% and 8%. But it actually varies according to the source of your information or the analyst you talk to. In this case we will assume that it is 5%.
Cost of Capital Assumptions
|Risk Free Rate of Interest|
It’s time to do some calculating.
Cost of Equity = Risk free rate of return + Beta * (Risk Premium)
Cost of Equity = 6% +1.4 * (5%) = 13%
The formula for Weighted Average Cost of Capital (WACC), an adjusted average of the cost of debt and cost of equity, is
WACC = Cost of Debt * (1- tax rate) * Weight + Cost of Equity * (1- Weight)
Where Weight = Debt / (Debt + Equity) and Debt =Long Term obligations of the business.
Let’s try to find AMD’s WACC for the year 2000
Weight = 2,859,033 / (2,859,033 + 6,013,829) = 32%
However, since we do not know the terms and conditions and debt structure of all of AMD’s loans, we cannot approximate their Cost of Debt. But just to show you how WACC works, we’ll hypothesize and say that it is around 11%
WACC = 11%
* (1 – 0) * 32% + 13% * (1-32%) = 12.4%
So the approximated WACC for AMD is 12.4%. This is the rate that should be used to discount AMD’s cash flows.