Depending on the means used to finance a project, costs will differ since the cost of raising debt and equity are different. The effective cost of capital (or cost of raising funds) for a project is measured in terms of the Weighted Average Cost of Capital (WACC). WACC takes into consideration the amount and cost of debt and equity raised for the project.
| The formula for WACC is WACC = E x Re + D x Rd x (1-T) E+D E+D Here, E = Market value of the company's equity D = Market value of the company's debt Re = Cost of Equity Rd = Cost of Debt or interest rate at which debt is raised T= Tax Rate applicable for the project |
The cost of debt depends on the risk free rate and spread. The cost of equity indicates the minimum rate of return a company must offer shareholders as compensation for waiting for returns and for bearing risk. It reflects the shareholders' opportunity cost of investment. The value of the cost of equity can be estimated based on the capital asset pricing model, in which the risk free rate and equity risk premium are estimated.
| Example For a project, funds are raised through debt and equity in the ratio 70:30. The interest rate on the debt is 12 per cent. The equity return expectation in the sector is estimated at 18 per cent. The present corporate tax rate is assumed to be 33 per cent. The WACC is then calculated as below. WACC = 30% * 18% + 70% * 12% * (1 -33%) = 11.028% The effective cost of raising funds for the project thus works out to 11.028 per cent. |