BUSF_A01.qxd

Weighted average cost of capital

Note that we used market values rather than the nominal values of the two ele-
ments as the weights. This correctly reflects the fact that we are seeking the opportun-
ity cost of capital. Market values reflect or indicate current opportunities; nominal
values do not. Despite this, Al-Ali and Arkwright (2000) found that 21 per cent of large
UK businesses use nominal values as the weights.

The appropriate discount rate lies above 8 per cent. Try 9 per cent:

Year Cash flow Discount factor Present value

££

0 (95.00) 1.000 (95.0)

1 7.70 0.917 7.1

2 7.70 0.842 6.5

3 107.70 0.772 83.1

1.7

Clearly the appropriate rate lies close to 9 per cent; a closer approximation may be obtained,
but it is doubtful whether there is any point in seeking more accuracy than the nearest whole
percentage (9 per cent). This is because:

l the cost of the other element in the financing (ordinary shares) has been calculated mak-
ing some fairly sweeping assumptions about future dividends; and

l the cash flows that will be discounted by the resulting WACC cannot be predicted with
any great accuracy.

We may say, then, that the cost of the loan notes, kL=9%.
Next we need to value the two elements:

(a)Ordinary shares. The total value of the ordinary shares:

VE=1 million ×£1.80 =£1.80 million

(b)Loan notes. The total value of the loan notes:

VL=800,000 ×=£0.76 million

Now that we have the costs and values of the two financing elements, we can go on to

calculate WACC.

WACC = kE×+kL×

= 16 ×+ 9 ×

=11.25 +2.67

=13.92%, say 14%

D

F

0.76

1.80 +0.76

A

C

D

F

1.80

1.80 +0.76

A

C

D

F

VL

VE+VL

A

C

D

F

VE

VE+VL

A

C

95

100