To make sound investment decisions, a corporation must know its hurdle rate—the average rate it pays to finance its assets. This is the Weighted Average Cost of Capital (WACC), which aggregates the costs of debt, preferred stock, and common equity based on their target market value weights:

WACC = w_d × r_d × (1 − t) + w_p × r_p + w_e × r_e

Where \(w_d, w_p, w_e\) represent the market value proportions of debt, preferred stock, and equity, respectively.

The cost of debt is the market yield to maturity (YTM) on a company’s outstanding long-term bonds, rather than the coupon rate. Because interest payments are tax-deductible under both US Internal Revenue Code (IRC) and European tax laws, debt provides an operational tax shield. The effective after-tax cost of debt is calculated as:

After-tax r_d = Pre-tax r_d × (1 − Marginal Tax Rate)

Preferred stock pays a fixed dividend indefinitely and has priority over common stock. Because these dividends are paid out of after-tax corporate income, they do not offer a tax shield. The cost is calculated using the perpetuity shortcut:

r_p = D_p / P_n

Where
D_p is the preferred dividend and
Pₙ is the net issuance price (market price minus flotation costs).

Firms estimate the required return on common equity using two primary methods:

Using a single corporate WACC for all projects can lead to poor decisions if a firm operates multiple business lines with varying risk levels. The firm uses the Pure-Play Method to find a publicly traded peer company dedicated to the target line of business.

The peer’s equity beta is “unlevered” to isolate its operational risk, then “relevered” to match the financial capital structure of the firm evaluating the project:

β_unlevered = β_levered / [ 1 + (1 − t) × (Debt / Equity) ]