In financial decision making, a firm finances its assets by either debt or equity. The weighted average cost of capital (WACC) measures the average riskiness of a firm’s assets by calculating the weight of debt and equity to any given situation. In effect, by calculating a weighted average, a firm can estimate the capital discount of debt and equity in dollar terms. This means that for each dollar it finances, it can derive the optimal capital structure for a certain percentage of cost of debt and cost of equity that, in return, will provide a return on investment (ROI) to the shareholders.
The risk undertaken in financing is reflected on different required rates on return that represent different classes of assets. For instance, if a firm has only common stocks, the required return on equity (ROE) is the cost of capital used in the calculations of WACC. As different classes of assets differ in the level of risk undertaken, the WACC is adjusted to reflect the total riskiness of the project. In other words, the WACC is the minimum return that the firm expects given its existing capital structure so that its shareholders are satisfied for owning its assets and undertaking the risk of ownership.
When a firm has also preferred stocks along with common equity, their weight has to be included in the calculation of the WACC, but they are not tax-adjusted.
WACC Calculation with preferred stocks
For the calculation of the WACC, the following formula is used:
WACC = Wd x Rd(1-T) + Ws x Rs + Wp x Rp
where:
• Wd: the weight of debt (percentage of debt allocated to finance the project)
• Ws: the weight of equity (percentage of equity allocated to finance the project)
• Wp: the weight of preferred stocks (percentage of preferred stocks allocated to finance the project)
The firm’s optimal capital structure determines the weights of each capital component. Moreover, the sum of the weights of all three components must equal 1.
• Rd(1-T) = after tax cost of debt (the rate of return that creditors require)
• Rs = cost of common equity (the rate of return on equity)
• Rp = cost of preferred stocks (the rate of return on preferred stocks without tax adjustments)
Example
We assume that firm X issues preferred stocks and we want to calculate the weighted average rate of return for a project that is considered to be undertaken.
In particular:
45% debt (Wd), 50% equity (Ws), 5% preferred stock (Wp), 7.5% cost of debt (Rd), 16% cost of equity (Rs) , 11% cost of preferred stock (Rp), 30% tax rate (T).
Wd = 45%
Ws = 50%
Wp = 5%
Rd = 7.5%
Rs = 16%
Rp = 11%
T = 30%
Then:
WACC = Wd x Rd(1-T) + Ws x Rs + Wp x Rp =45% x 7.5% (1-30%) + 50% x 16 % + 5% x 11% =
= 2.36 + 8 + 0.55 = 10.91%
