Chapter 11, Problem 13PROB

Summary Introduction

Weighted Average Cost of Capital (WACC) is the required rate of return investors would expect from the company. If a company uses a combination of financing alternatives to fund its business, it should calculate an average cost of capital. Various long-term funds include debt, equity and preferred stock. Regardless of the mode of financing for a project, a company’s WACC should be considered in making capital budgeting decisions.

An optimal capital structure of a company is a mix of debt, equity and preferred stock which can be used to maximize the company’s stock price. Therefore, a target proportion of capital structure and cost of each financing can be used to determine the WACC of the company.

$WACC=w_d\left(r_{dT}\right)+w_{ps}\left(r_{ps}\right)+w_s\left(r_{s}or{r}_e\right)$

Here,

Proportion of debt in the target capital structure “$w_d$”

Proportion of preferred stock in the target capital structure “$w_{ps}$

Proportion of equity in the target capital structure “$w_s$”

After tax cost of debt, preferred stock, retained earnings and new equity is “$r_{dT}$”,“$r_{ps}$”,“$r_s$”and “$r_e$”, respectively.