Final answer:
WACC is calculated by weighing the costs of equity, debt, and preferred stock based on the firm's capital structure. It is the right discount rate to use for valuing a levered firm, reflecting the cost and risk of borrowing money.
Step-by-step explanation:
To use the Weighted Average Cost of Capital (WACC) approach to value a levered firm, assess the cost of each type of capital, including equity, debt, and preferred stock, and then weight them based on the firm's capital structure. After calculating the WACC, it will serve as the discount rate for future free cash flows of the firm. These cash flows are then discounted to the present value using the WACC, which is the right discount rate to use for a levered firm because it considers the different costs of capital, adjusted for their weights and the corporate tax rate.
Calculating WACC involves the proportionate weighting of each class of capital, with the cost of debt being affected by the tax-deductible nature of interest payments. The end result is a reflective measure of a firm's cost to borrow money, accounting for the relative riskiness of different funding sources. Therefore, when valuing a firm, cash flows should be discounted at the WACC, providing a valuation reflective of the risks and costs associated with the capital structure that includes debt (levered).