This document discusses the weighted average cost of capital (WACC) calculation for a firm with multiple sources of capital (debt, preferred stock, common equity). It provides an example calculation showing the cost, proportion of total financing, and weighted cost for each source. The weighted costs are summed to calculate the overall WACC of 11.38%. The document also discusses assumptions and methods used in the WACC calculation, such as using after-tax costs and a constant growth valuation model to determine the cost of equity.

1. Prepared by:
Jammie Ann Felipe

2. *
*Can be used only if the current projects
of the firm are of similar risk and that
investment proposals under
consideration are of the same character
*Its advantage?
SIMPLICITY
*Required rate of return that will justify
all capital providers

3. *
(1) (2) (3) (2) x (3) (1) x (2)
Capital
Providers
Invested
Capital
Percentage
Annual Cost
(Investor
Return)
Proportion of
Total Financing
Wighted Cost
Dollar Annual
Cost (Investor
Return)
Shula $2,000.00 5% 20% 1.00% $100.00
Lia 3,000.00 10% 30% 3.00% $300.00
Jam 5,000.00 15% 50% 7.50% $750.00
10,000.00 100% 11.50% $1,150.00

4. *
(1) (2) (3) (2) x (3) (1) x (2)
Capital Providers
Invested
Capital
Percentage
Annual Cost
(Investor
Return)
Proportion of
Total Financing
Wighted Cost
Dollar Annual
Cost (Investor
Return)
Debt $2,000.00 5% 20% 1.00% $100.00
Preferred Stock 3,000.00 10% 30% 3.00% $300.00
Common Stock 5,000.00 15% 50% 7.50% $750.00
10,000.00 100% 11.50% $1,150.00

5. *
Long-Term
Capital
Long-Term
Debt
Preferred
Stock
Common
Stock
Retained
Earnings
New Common
Stock

6. *
*Stockholders focus on A-T CFs.
Therefore, we should focus on A-T
capital costs, i.e. use A-T costs of
capital in WACC. Only rd needs
adjustment, because interest is tax
deductible.

7. *
*We ignore non seasonal debt that
bears an explicit interest cost
*We are concerned on long term debt
*We assume that the firm is following
hedging (maturity matching)

8. *
*Ki = Kd (1-t)
where Ki after-tax cost debt
Kd discount rate or YTM
t company’s marginal
tax rate
Example: Interest Rate 11%
Marginal Tax Rate 40%
Ki = .11 (1 – 0.40)
= 6.6% Cost of Additional Debt

9. *
*KP = DP / PO
Where KP Interest Rate
DP Dividend
PO Current Market Price
Example: 10% Preferred Stock Issue ($50 par value)
at a current market price of $49.00
KP = DP / PO
= $5 / $49
= 10.20% Explicit Cost of Preferred Stock

10. *
*More risky; company not required to
pay preferred dividend.
*However, firms try to pay preferred
dividend. Otherwise, (1) cannot pay
common dividend, (2) difficult to raise
additional funds, (3) preferred
stockholders may gain control of firm.

11. *
*Earnings can be reinvested or paid out as dividends.
*Investors could buy other securities, earn a return.
*If earnings are retained, there is an opportunity cost
(the return that stockholders could earn on
alternative investments of equal risk).
*Investors could buy similar stocks and earn ks.
*Firm could repurchase its own stock and earn ks.

12. *
*When a company issues new common stock
they also have to pay flotation costs to the
underwriter.
*Issuing new common stock may send a
negative signal to the capital markets, which
may depress the stock price.

13. *
*Example: If dividends are expected to
grow at an 8% annual rate into the
foreseeable future, the constant growth
model, discussed in Stock Valuation,
may be used to determine the required
rate of return.
*If the expected dividend in the first
year were $2 and the present market
price were $27

14. *
*Ke = (D1 / PO) + g
= ($2 / $27) + 0.08
= 15.4% Cost of Equity

15. *
*CAPM rs = rRF + (rM – rRF)b
*Example:
The rRF = 7%, RPM = 6%,
and the firm’s beta is 1.2.
Find Cost of Common Equity?
rs = rRF + (rM – rRF)b
= 7.0% + (6.0%)1.2
= 14.2% Cost of Equity

16. *
*When a company issues new common
stock they also have to pay flotation costs
to the underwriter.
*Issuing new common stock may send a
negative signal to the capital markets,
which may depress the stock price.

17. *
Amount of
Financing
Proportion of
Total Financing
Debt 30 million 30%
Preferred Stock 10 million 10%
Common Stock Equity 60 million 60%
$100 million 100%
Cost
Debt 6.60%
Preferred Stock 10.02%
Common Stock Equity 14.00%

18. (1) (2) (1) x (2)
Cost
Proportion of
Total Financing
Weighted Cost
Debt 6.60% 30% 1.98%
Preferred Stock 10.02% 10% 1.00%
Common Stock Equity 14.00% 60% 8.40%
100% 11.38%
*

19. *