Cost of capital (Part II) – Practical applications
In part 1 of this series, we learned how to calculate the cost of different forms of financing -- debt, preferred equity, and common equity. In this article, we’ll cover some ways that information can be used to make sound business decisions.
1. Weighted Average Cost of Capital (WACC)
For the first part of this article series, refer to Cost of capital (Part I) – Theory and concepts.
The first thing we can do with the different costs we calculated in part 1 is to use them into determining weighted-average cost of capital, or WACC. An average cost of capital gives us a good estimate of the minimum return on investment (ROI) for the business.
Weighted-average cost of capital (WACC) is the average cost of each type of capital of an entity (e.g., common stock, preferred stock, debt) adjusted for the weight of such capital types within the entire capital structure of the entity.
We can calculate WACC by multiplying cost of debt, cost of preferred equity, and cost of common equity by the percentage of total capital associated with that type of financing. Let’s go back to the XY Corporation example we started in part 1. For this part of the series, we’ll assume the corporation has the following capital structure:
Form of Financing |
Amount of |
Percentage of |
Debt – 8% before-tax cost of capital |
$10,000,000 |
22.2% (=$10 mil ÷ $45 mil) |
Preferred Stock – 7% cost of capital |
$5,000,000 |
11.1% (=$5 mil ÷ $45 mil) |
Common Stock – 11% cost of capital* |
$30,000,000 |
66.7% (=$30 mil ÷ $45 mil) |
Total |
$45,000,000 |
100% |
(*) Calculated using the capital asset pricing model (CAPM)
The margin tax rate for the corporation is 40%.
First, we need to adjust the cost of debt to account for tax savings associated with interest payments. The after-tax cost of debt is 4.8% (i.e., 8% x (1 - 0.4)).
Next, we can calculate WACC:
Form of Financing |
Cost of Capital |
Percentage of |
WACC |
Debt |
4.8% |
22.2% |
1.07% (= 4.8 x 22.2%) |
Preferred Equity |
7% |
11.1% |
0.78% (= 7 x 11.1%) |
Common Equity |
11% |
66.7% |
7.34% (= 11 x 66.7%) |
Total |
9.19% |
We can also determine what WACC would be if we made some sort of change in the capital structure. For example, XY Corporation could issue $5,000,000 in bonds and exercise a call option on all preferred shares. The capital structure would then be $15,000,000 of debt and $30,000,000 of common equity. The WACC calculation would be the same as above, except that preferred equity would be removed from the scenario and debt would be increased by $5,000,000.
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