Cost of Capital
Weighted Average Cost of Capital (WACC)
Now that we have calculated all our component costs, calculating the WACC is simple. We plug into our formula and solve.
| Variable | = | Definition |
|---|---|---|
| rd | = | Interest rate on firm’s debt. Or the return on debt. |
| rd(1 − T) | = | After-tax cost of debt. |
| rps | = | Return on preferred stock |
| rs | = | Return on common stock |
| wd | = | Weight (%) of debt used by the company |
| wps | = | Weight (%) of preferred stock used by the company |
| ws | = | Weight (%) of common stock used by the company |
| WACC | = | Weighted Average Cost of Capital |
| DPS | = | Dividend of Preferred Stock |
| PPS | = | Price of Preferred Stock |
| g | = | The growth rate of dividends of common stock |
| P0 | = | Price in time zero of a share of common stock |
| D0 | = | Dividend in time zero |
| D1 | = | Dividend in time 1 |
Table 12.1 Components of WACC
The weighted average cost of capital (WACC)
takes the return from each component and then appropriately 'weights'
it based on the percentage used for financing. The weights must sum to
one, and it is easiest to use decimals. In words, the equation is:
Equation 12.7 WACC components (words)
WACC = (% of debt)(After-tax cost of debt) + (% of preferred stock)(cost of preferred stock) + (% of common stock)(cost of common stock)
or
WACC = (% of debt)(Before-tax cost of debt)(1−T) + (% of preferred stock)(cost of preferred stock) + (% of common stock)(cost of common stock)
Using symbols, the equation is:
Equation 12.8 WACC components (symbols)
WACC = wdrd(1 − T) + wpsrps + wsrs
Worked Example: Falcons Footwear – CAPM to calculate rs
Falcons Footwear has 12 million shares of common stock selling for $60/share, 2 million shares of preferred stock selling for $85/share, and $100 million in bonds trading at par. It is in the 40% tax bracket.
First, we calculate the total market value:
Total market value of common stock = 12 million*$60 each = $720 million
Total market value of preferred stock = 2 million shares*$85 each = $170 million
Total market value of bonds = $100 million trading at par = $100 million
Total market value = 720 + 170 + 100 = $990 million
From this, we get the weights:
Percentage of common stock = $720 / $990 = 72.7%
Percentage of preferred stock = $170 / $990 = 17.2%
Percentage of debt = $100 / $990 = 10.1%
Total equals = 100%
Then, we plug in the weights and the component costs.
WACC = wdrd(1 − T) + wpsrps + wsrs
WACC = (0.101)(0.07)(1−0.4) + (0.172)(0.0882) + (0.727)(0.092)
WACC = 0.0042 + 0.0152 + 0.0668 = 0.0862 or 8.62%
For Falcons Footwear, the WACC is 8.62%.
Key Takeaway
- The Weighted Average Cost of Capital is the component returns multiplied by their respective weights.
Exercises
-
Calculate WACC given the following:
rs = 6 percent%, rd = 10%, rps = 4%, wd = 40%, ws = 50%, wps = 10%
-
Calculate WACC given the following:
rs = 5.5%, rd = 4.5%, rps = 7%, wd = 35%, ws = 45%, wps = 20%