Calculating the Weighted Average Cost of Capital (WACC) for Kogello Limited

A Comprehensive Guide to Determining Kogello Limited's WACC Using Market Weights

Key Takeaways

Accurate Market Valuation: Determining the precise market values of all capital components is crucial for an accurate WACC calculation.
Cost of Each Component: Understanding and correctly calculating the cost of equity, preference shares, and debt ensures the WACC reflects the true cost of capital.
Proper Weight Allocation: Allocating the correct weights to each capital component based on market values ensures a balanced and accurate WACC.

Introduction to WACC

The Weighted Average Cost of Capital (WACC) is a fundamental financial metric used to assess a company's cost of capital from all sources, including equity and debt. It represents the average rate that a company is expected to pay to finance its assets. Calculating WACC accurately is essential for investment decisions, valuation, and strategic planning.

Understanding the Components

1. Ordinary Share Capital

Ordinary share capital represents the equity capital raised by issuing common shares to investors. It is a primary source of funding for the company.

2. Preference Share Capital

Preference shares are a hybrid form of financing that possess characteristics of both equity and debt. They typically offer fixed dividends and have priority over ordinary shares in dividend distribution and asset liquidation.

3. Debentures (Debt)

Debentures are long-term debt instruments issued by the company to investors. They bear interest and must be repaid at maturity, making them a critical component of the company's capital structure.

Step-by-Step Calculation of WACC

Step 1: Calculate the Market Value of Each Capital Component

Determining the market value of each component involves calculating the total value based on the number of shares and their respective market prices.

1. Ordinary Shares

Par Value per Share: Sh. 25
Number of Ordinary Shares: 8,000,000 / 25 = 320,000 shares
Market Price per Share: Sh. 30
Market Value: 320,000 shares * Sh. 30 = Sh. 9,600,000

2. 8% Preference Shares

Par Value per Share: Sh. 24
Number of 8% Preference Shares: 6,000,000 / 24 = 250,000 shares
Market Price per Share: Sh. 20
Market Value: 250,000 shares * Sh. 20 = Sh. 5,000,000

3. 10% Preference Shares

Par Value per Share: Sh. 20
Number of 10% Preference Shares: 4,000,000 / 20 = 200,000 shares
Market Price per Share: Sh. 25
Market Value: 200,000 shares * Sh. 25 = Sh. 5,000,000

4. Debentures

Market Value of 10% Debentures: Sh. 5,000,000

Total Market Value of Capital

Capital Component	Market Value (Sh.)
Ordinary Shares	9,600,000
8% Preference Shares	5,000,000
10% Preference Shares	5,000,000
Debentures	5,000,000
Total	24,600,000

Step 2: Determine the Cost of Each Capital Component

Calculating the cost associated with each capital component is essential to understand the company's overall cost of capital.

1. Cost of Ordinary Equity (Ke)

The cost of ordinary equity can be estimated using the Dividend Yield approach:


Cost of Equity (Ke) = Dividend per Share / Market Price per Share
Ke = 3.80 / 30 = 0.1267 or <b>12.67%</b>

2. Cost of 8% Preference Shares (Kp1)

The cost of preference shares is calculated based on the fixed dividend and the market price:


Cost of 8% Preference Shares (Kp1) = (Dividend per Share) / Market Price per Share
Kp1 = (0.08 * 24) / 20 = 1.92 / 20 = 0.096 or <b>9.6%</b>

3. Cost of 10% Preference Shares (Kp2)

Similarly, for the 10% preference shares:


Cost of 10% Preference Shares (Kp2) = (Dividend per Share) / Market Price per Share
Kp2 = (0.10 * 20) / 25 = 2.00 / 25 = 0.08 or <b>8%</b>

4. Cost of Debentures (Kd)

The cost of debt considers the interest rate and the tax shield provided by interest deductions:


Cost of Debt (Kd) = Interest Rate * (1 - Tax Rate)
Kd = 10% * (1 - 0.30) = 10% * 0.70 = <b>7%</b>

Step 3: Calculate the Market Weights of Each Capital Component

Market weights are determined by dividing the market value of each component by the total market value of the company's capital.


Weight of Ordinary Shares = 9,600,000 / 24,600,000 ≈ 0.3902 or 39.02%
Weight of 8% Preference Shares = 5,000,000 / 24,600,000 ≈ 0.2033 or 20.33%
Weight of 10% Preference Shares = 5,000,000 / 24,600,000 ≈ 0.2033 or 20.33%
Weight of Debentures = 5,000,000 / 24,600,000 ≈ 0.2033 or 20.33%

Step 4: Apply the WACC Formula

The WACC formula aggregates the costs of all capital components, weighted by their respective proportions in the company's capital structure.


WACC = (Weight₁ × Cost₁) + (Weight₂ × Cost₂) + (Weight₃ × Cost₃) + (Weight₄ × Cost₄)
WACC = (0.3902 × 12.67%) + (0.2033 × 9.6%) + (0.2033 × 8%) + (0.2033 × 7%)
WACC = 0.0494 + 0.0195 + 0.0163 + 0.0142
WACC = <b>0.0994 or 9.94%</b>

Detailed Calculation Breakdown

Capital Component	Market Value (Sh.)	Cost	Weight	Weight × Cost
Ordinary Shares	9,600,000	12.67%	39.02%	4.94%
8% Preference Shares	5,000,000	9.6%	20.33%	1.95%
10% Preference Shares	5,000,000	8%	20.33%	1.63%
Debentures	5,000,000	7%	20.33%	1.14%
Total WACC				9.94%

Conclusion

After meticulously calculating the market values, determining the costs of each capital component, and accurately allocating their respective weights, the Weighted Average Cost of Capital (WACC) for Kogello Limited as of 31 March 2015 is 9.94%. This WACC serves as a critical benchmark for the company, influencing investment decisions, valuation assessments, and strategic financial planning.

References

For a deeper understanding of WACC and its calculation, the following resources provide valuable insights: