To calculate the firm's weighted average cost of capital (WACC), you need to determine the cost of each form of financing: aftertax cost of debt, cost of preferred stock, and cost of equity. The WACC is calculated by weighting each cost by the proportion of each form of financing in the firm's capital structure.
In order to calculate the firm's weighted average cost of capital (WACC), we need to determine the cost of each form of financing: aftertax cost of debt, cost of preferred stock, and cost of equity.
Aftertax cost of debt:
The aftertax cost of debt can be calculated using the formula:
Aftertax cost of debt = Pre-tax cost of debt x (1 - Tax rate)
For example, if the pre-tax cost of debt is 6% and the tax rate is 30%, the aftertax cost of debt would be 4.2%.
Cost of preferred stock:
The cost of preferred stock can be calculated using the formula:
Cost of preferred stock = Preferred stock dividend / Preferred stock price
For example, if the preferred stock dividend is $2 and the preferred stock price is $50, the cost of preferred stock would be 4%.
Cost of equity:
The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM).
Once we have determined the cost of each form of financing, we can calculate the WACC by weighting each cost by the proportion of each form of financing in the firm's capital structure. The formula for WACC is:
WACC = (Weight of debt x Cost of debt) + (Weight of preferred stock x Cost of preferred stock) + (Weight of equity x Cost of equity)
For example, if the firm's capital structure consists of 40% debt, 10% preferred stock, and 50% equity, and their respective costs are 4.2%, 4%, and 8%, the WACC would be calculated as follows:
WACC = (0.4 x 4.2%) + (0.1 x 4%) + (0.5 x 8%)
By plugging in the values and performing the calculations, we can determine the firm's WACC.