Cost of Capital: Calculation and Application of Weighted Average Cost of Capital
Overview
This paper explains the concept of cost of capital and its components, including debt, preferred stock, and common stock. It demonstrates the calculation of weighted average cost of capital (WACC) through practical examples using different capital structure scenarios for a company.
What this coursework covers
- Definition and overview of cost of capital
- Calculation of cost of debt with tax adjustment
- Calculation of cost of preferred and common stock
- WACC formula and methodology
- Two comparative examples of WACC calculations with different capital structures
Preview
Cost of capital
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The Cost of capital
In simple terms, it is the cost that an organization uses in funding its operations. The cost can be categorized as debt and equity.
Marginal tax rate 35%
Coupon rate of 8%
rd= 0.08(1-0.35)
rd = 0.52 (cost of debt)
The cost of debt is multiplied by (1- tax rate). The reason for this is that interest rate expense is allowed as a deduction when calculating taxes. Tax deductibility generates a saving that must be accounted for (Frank, M. Z., & Shen, T. 2016.
The Cost of preferred stock (rp) = preferred dividend per share/current stock price
rp = $2.50 / $25 = 10%
The Cost of Common Stock (re) =
re = $1.50 / $20 + 5 percent =
7.5 percent + 5 percent = 12.5%
If Bad Boys Inc. raises capital using a debt of 45%, preferred stock of 5 percent, and a common stock of 50%; the cost of capital would be:
The method for calculating the WACC (weighted average cost of capital) is:
Cost of Capital = wd × rd × (1 - tax) + wp × rp + we × re
wd is the relative debt percentage
wp is the preferred stock
we is the common stock
WACC = [(0.45 *0.052)* (1-0.35)] + (0.05* 0.10) + (0.50 *0.125)
WACC = (0.0234 * 0.65)+ 0.005 + 0.0625 = 0.2196 = 21.96%
Weighted average cost of capital would be 21.