Weighted Average Cost of Capital (WACC) Calculation - CFA® Level 1 Exam Prep

WACC Calculation

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Question

Helmut Humm, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace a person who left suddenly. One of Humm's first tasks is to calculate the company's weighted average cost of capital (WACC) "" and fast! The CEO is scheduled to present to the board in half an hour and needs the WACC "" now! Luckily, Humm finds clear notes on the Target capital component weights in the current workpapers. Unfortunately, all he can find for the cost of capital components is some handwritten notes. He can make out the numbers, but not the corresponding capital component. As time runs out, he has to guess.

Here is what Humm deciphered:

If Humm guesses correctly, the WACC is:

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Explanations

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A. B. C. D.

Explanation

If Humm remembers to order the capital components from cheapest to most expensive, he can calculate WACC. The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid of debt and equity), retained earnings, and common stock. (Remember that internal equity "" retained earnings is cheaper than external equity ""common equity due to floatation costs.)

Then, using the formula for WACC = (wd)(kd) + (wps)(kps) + (ws)(ks)+ (we)(ke) where wd, wps, wsandweare the weights used for debt, preferred stock, retained earnings, and common equity.

WACC = (0.30 * 6.0%) + (0.20 * 8.5%) + (0.15 * 11.00%) + (0.35 * 15.0%) =10.4%.

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