Chapter 10, Problem 8P

Summary Introduction

To identify: The cost of common equity and WACC.

Cost of Equity:

It is the cost of the company while raising finance by issuing equity. It is earnings from the investment to the firm’s equity investors. It is the return to the stockholder holders’ equity investments.

Weighted Average Cost of Capital (WACC):

It is the weighted average cost of all the sources through which firm finances its capital. It is that rate that company will pay to all for raising finance. It can be termed as firm’s cost of capital.

The company raises money through various sources such as common stock, preference share debt the WACC is calculated taking the relative weight of each item of capital structure.

The formula to calculate WACC is,

$\text{WACC}={\text{W}}_{\text{d}}{\text{r}}_{\text{d}}\left(1-\text{t}\right)+{\text{W}}_{\text{P}}{\text{r}}_{\text{p}}+{\text{W}}_{\text{c}}{\text{r}}_{\text{s}}$

Where,

• ${\text{W}}_{\text{d}}$ is the weight of the debt.
• ${\text{W}}_{\text{P}}$ is the weight of the preferred stock.
• ${\text{W}}_{\text{c}}$ is the weight of the equity.
• ${\text{r}}_{\text{d}}$ is cost of the debt.
• ${\text{r}}_{\text{P}}$ is cost of the preferred stock.
• ${\text{r}}_{\text{c}}$ is the cost of the equity.