1. The Concept of Cost of Capital
The cost of capital acts as the firm’s dynamic hurdle rate. It represents the minimum rate of return a corporation must earn on its investments to satisfy its debt providers and equity investors.
Â
2. Calculating Individual Component Costs
-
After-tax cost of debt:
After-tax Cost of Debt = r_d × (1 − T) -
Cost of preferred stock:
r_p = D_p / P_0 -
Cost of common equity (CAPM):
r_s = R_f + β × (R_m − R_f)
3. Weighted Average Cost of Capital (WACC) Formulation
The individual component costs are aggregated according to their proportional market value weights within the firm’s capital structure:
WACC = (w_d × r_d × (1 − T)) + (w_p × r_p) + (w_s × r_s)
Where: \(w_d, w_p, w_s\) represent the target market value weights of debt, preferred stock, and common equity respectively.
WACC = (w_d × r_d × (1 − T)) + (w_p × r_p) + (w_s × r_s)
Where: \(w_d, w_p, w_s\) represent the target market value weights of debt, preferred stock, and common equity respectively.
Â