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Cost of Capital Formulas

This document summarizes the formulas used to calculate the weighted average cost of capital (WACC). It outlines the component costs of debt, preferred stock, and common equity which are weighted and combined to determine WACC. The component costs are calculated using methods like the after-tax cost of debt, dividend yield for preferred stock, and discounted cash flow or capital asset pricing models for equity. The WACC is the blended rate used to evaluate investments and determine if projects will create value.

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Gabrielle Vapor
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615 views2 pages

Cost of Capital Formulas

This document summarizes the formulas used to calculate the weighted average cost of capital (WACC). It outlines the component costs of debt, preferred stock, and common equity which are weighted and combined to determine WACC. The component costs are calculated using methods like the after-tax cost of debt, dividend yield for preferred stock, and discounted cash flow or capital asset pricing models for equity. The WACC is the blended rate used to evaluate investments and determine if projects will create value.

Uploaded by

Gabrielle Vapor
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CHAPTER 10: Cost of Capital

SUMMARY

AMOUNT COMPUTED FORMULA

Weighted Average Cost


of Capital (WACC)
𝑤𝑑 𝑟𝑑 (1 − 𝑇) + 𝑤𝑝 𝑟𝑝 + 𝑤𝑐 𝑟𝑠

Component Cost of Debt (rd)

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑜𝑛 𝑁𝑒𝑤 𝐷𝑒𝑏𝑡 − 𝑇𝑎𝑥 𝑆𝑎𝑣𝑖𝑛𝑔𝑠

After-tax Cost of Debt 𝑟𝑑 − 𝑟𝑑 𝑇

𝑟𝑑 (1 − 𝑇)

Component Cost of Preferred Stock (rp)

Component Cost of 𝐷𝑝
𝑟𝑝 =
Preferred Stock 𝑃𝑝

Component Cost of Common Equity

Cost of Equity from 𝐷1


𝑟𝑅𝐹 + 𝑅𝑃 = + 𝑔 = 𝑟̂𝑠
Retained Earnings (rs) 𝑃0

↳ Discounted Cash Flow 𝐷1


+𝑔
(DCF) Approach 𝑃0

↳ Capital Asset Pricing 𝑟𝑅𝐹 + (𝑅𝑃𝑀 )𝑏𝑖


Model (CAPM) Approach
𝑟𝑅𝐹 + (𝑟𝑀 − 𝑟𝑅𝐹 )𝑏𝑖
↳ Bond-Yield-Plus-Risk-
𝐵𝑜𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 + 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚
Premium Approach
Cost of Equity from 𝐷1
𝑟𝑒 = +𝑔
New Stock (re) 𝑃0 (1 − 𝐹)

Others

Flotation Cost
𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝐷𝐶𝐹 𝐶𝑜𝑠𝑡 − 𝑃𝑢𝑟𝑒 𝐷𝐶𝐹 𝐶𝑜𝑠𝑡
Adjustment
Cost of External Equity 𝑟𝑠 + 𝐹𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡 𝐴𝑑𝑗𝑢𝑠𝑡𝑚𝑒𝑛𝑡
Retained Earnings 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑌𝑒𝑎𝑟
Breakpoint 𝐸𝑞𝑢𝑖𝑡𝑦 𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛
Where:

 rd = Interest rate on firm’s new debt (Before-tax component of cost of debt)


 rp = Component cost of preferred stock
 rs = Component cost of common (internal) equity raised by retained earnings
= Required rate of return
 re = Component cost of common (external) equity raised by issuing new stock
 wd = Target weight of debt
 wp = Target weight of preferred stock
 wc = Target weight of common equity
 Dt = Dividend a stockholder expects to receive at the end of each year
 Pt = Expected price and expected intrinsic value of the stock at the end of each year
 g = Expected growth rate

NOTE: For the full (non-summarized) list of formulas, please refer to Appendix C of your
Cengage eBook.

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