Question

What is cost of capital? How do you calculate WACC?

Answer 1

Cost of capital is the minimum rate of return that the company must earn in order to fulfill investor expectations. To maximize shareholder’s wealth, a company has to earn more than the cost of capital. The cost of capital measures the cost of the different sources of capital of the firm. The cost of capital can be calculated by determining the weighted average cost of the different sources of capital.

The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+Wps*Kps+We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

Cost of debt

The cost of debt is adjusted for the tax rate. The reason being the interest paid on corporate debt is tax deductible. The after tax cost of debt is calculated as Kd(1-t).

Cost of preferred stock

Cost of preferred stock is the price paid by a firm for the costing of issuing preferred stock. It is the return expected by the holders of preferred stock. It is calculated by dividing the preferred stock dividend paid in a year by the market price of the preferred stock.

Cost of preferred stock:

Kps=Dps/P

where:

Kps= Cost of preferred stock

Dps=preferred dividend

P= Market price of preferred stock

Cost of Equity

Cod of equity is the required rate of return on the company’s common stock. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM).

The formula for calculating the capital asset pricing model is given below:

Ke=Rf+[E(Rm)-Rf]

where:

Rf=risk-free rate of return which is the yield on default free debt like treasury notes

Rm=expected rate of return on the market.

= Beta of the company

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