Unit 8: Working Capital Management
Weighted Average Cost of Capital (WACC)
279 of 319 · 382 words
From Principles of Finance by Saylor Academy, used under the CC BY 3.0 licence. Written for a general audience, not for NEPSE.
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 |
|---|---|---|
| r d | = | Interest rate on firm’s debt. Or the return on debt. |
| r d (1 − T) | = | After-tax cost of debt. |
| r ps | = | Return on preferred stock |
| r s | = | Return on common stock |
| w d | = | Weight (%) of debt used by the company |
| w ps | = | Weight (%) of preferred stock used by the company |
| w s | = | Weight (%) of common stock used by the company |
| WACC | = | Weighted Average Cost of Capital |
| D PS | = | Dividend of Preferred Stock |
| P PS | = | Price of Preferred Stock |
| g | = | The growth rate of dividends of common stock |
| P 0 | = | Price in time zero of a share of common stock |
| D 0 | = | Dividend in time zero |
| D 1 | = | Dividend in time 1 |
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)
WACC = (% of debt)(Before-tax cost of debt)(1−T) + (% of preferred stock)(cost of preferred stock) + (% of common stock)(cost of common stock)
Equation 12.8 WACC components (symbols)
WACC = w d r d (1 − T) + w ps r ps + w s r s
Worked Example: Falcons Footwear – CAPM to calculate r s
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
Percentage of common stock = $720 / $990 = 72.7%
Percentage of preferred stock = $170 / $990 = 17.2%
Then, we plug in the weights and the component costs.
WACC = w d r d (1 − T) + w ps r ps + w s r s
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%
Key Takeaway
Exercises
- 1Calculate WACC given the following: r s = 6 percent%, r d = 10%, r ps = 4%, w d = 40%, w s = 50%, w ps = 10%
- 2Calculate WACC given the following: r s = 5.5%, r d = 4.5%, r ps = 7%, w d = 35%, w s = 45%, w ps = 20%
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