Calculation of Weighted Average Cost of Capital
Company Name: Reliance Industries Limited. Balance Sheet date: 31st March 2008: Market Values date: 29th August 2008.
(Note: Number of equity shareholding (in Million) = 1453.39
(Reliance Industries limited, 2008).
The Capital Structure Decision and the Cost of Capital
Cost of capital is the rate of return which a company must earn on its investments, in order to satisfy the expectations of investors. A company’s wealth of equity can be enhanced by earning more than the cost of capital.
The weighted average cost of capital is a method of finding the companies’ cost of capital by applying proportionate weight for each source of finance. In this model, each factor of the total finance of the firm is multiplied with its proportionate weight and then sum up these figures. Firms always employ different sources for their finance. In WACC the average cost of each source of finance is taken into account on the percentage of total finance. Through the calculation of WACC, the overall required rate of return on the funds of the firm can be estimated. (Weighted average cost of capital – WACC).
The average cost involved on each source of finance of firms including shareholders equity, long term, and short term debt is weighted based on the proportion of each component to the total finance. It is always based on the market value of each component of finance and after considering tax costs. It is a useful tool for formulating optimum capital structure decisions by calculating the required rate of return on each source of finance by the firm. (Business definition for Weighted average cost of capital, 2008).
WACC is the overall return that is required by companies to earn through their business operations for maintaining the current value of the outstanding stock of companies.
Report on the Computation of Weighted Average Cost of Capital of Reliance Industries Limited
The balance sheet of the company for the year ending 31st March 2008 is taken as the base. For calculating the weighted average cost of capital of the Reliance Industries limited
The share holders’ equity is found out by taking into account the Equity capital, Reserves, and Surplus, which form part of the shareholders’ owned fund of the company. The total share holders’ equity of the company is $778630.1 Million.
While calculating the market value of the shares on 29th August 2008, $2136.75 per share for outstanding 1453.39 Million shares amounts to $ 3869627.2825 million.
The company’s short-term liabilities amount to $ 212504.67 Million for which the market value is assumed to be the same as that of its book value.
Long-term liabilities have a book value of $364796 million. For calculating the current market value of long-term loans a time PV factor of 0.5 is added to the book value of 1. Then by multiplying the book value with added PV factor of 1.5, $ 383035.8 Million as the current market value of long-term debt.
For calculating the percentage of each source of funds to the total fund of the company of $ 4465167.7 Million, each specific source of finance is divided by the total finance on a percentage basis. Thus we get short-term liabilities as 4.7592 %, long-term liabilities as 8.5783 %, and shareholders fund as 86.6625 % towards the total finance of the company.
For finding the total cost of each source of finance the interest rate payable on each source is taken into account. For finding the cost of short-term funds, the interest rate payable by Reliance Industries Limited is assumed as 8 % per annum. The cost of short-term liabilities is the after-tax cost. Thus to find out the cost of short-term liabilities, the tax rate of 34 % is deducted from 1 and the remainder 0.64 is multiplied with the interest rate, 8 % of short-term funds. Thus 5.28 % is derived as the cost of short-term debt of the company.
In order to find out the cost of long-term debt, it is assumed that the interest rate offered by the company on long-term debt is 11 % per annum. Interest on debt of the company is deductible from taxable income. For this, the tax of 34 % has to be deducted from the interest cost. Thus by multiplying the interest rate of 11 % with the after-tax rate of 0.64, 7.26 % is derived as the cost of long-term debt of the company.
It is assumed that the Reliance industries’ dividend rate per annum is 9 %. Thus the cost of shareholders’ funds is 9 %.
In the next step, the cost of each source of finance is multiplied by their corresponding proportional rate. Thus 0.251286 % for short-term funds, 0.622784 %for long-term funds, and 7.799625% for share holders’ equity are gained. By summing up these figures 8.673695 % is gained as the Weighted Average cost of Capital of Reliance Industries Limited.
From this, it could be estimated that in order to maintain the current market value of Reliance Industries Limited, it would have to earn a return of 8.67 % on all its assets and business operations.
References
Reliance Industries limited. (2008). Balance sheet of reliance industries limited for the year. myiris. Web.
Weighted average cost of capital – WACC. (2008). Investopedia. Web.
Business definition for: Weighted average cost of capital. (2008). BNET Business Dictionary. Web.