Chapter 12, Problem 12.1C

Section 12.1    What are the components used to construct the WACC?

Summary Introduction

To discuss: The components of the weighted average cost of capital (WACC).

Introduction:

The cost of capital refers to the return that the investors expect on a particular investment. In other words, it refers to the compensation demanded by the investors for using their capital.

The weighted average cost of capital (WACC) refers to the weighted average of the cost of debt after taxes and the cost of equity.

Explanation of Solution

The method of calculating the weighted average cost of capital:

The company raises capital from different sources. Hence, to calculate the overall cost of capital, the company needs to determine the weighted average of the costs of different types of capital sources. The following formula helps to calculate the weighted average cost of capital (WACC):

$WACC=\left(\frac{E}{V}\right)\times R_E+\left[\left(\frac{D}{V}\right)\times R_D\times \left(1-T_C\right)\right]$

Where,

“WACC” refers to the weighted average cost of capital

“R_E” refers to the return on equity

“R_D” refers to the return on debt

“E” refers to the market value of equity capital

“D” refers to the market value of debt

“V” refers to the total market value of debt and equity

“T_C” refers to the corporate tax rate

The components of the weighted average cost of capital:

The weighted average cost of capital uses the weighted average cost of all the capital sources of the company. Hence, the following components are used to construct the weighted average cost of capital:

• Cost of equity
• Cost of preferred stock
• Cost of debt
• The weight of equity in the capital structure
• The weight of preferred stock in the capital structure
• The weight of debt in the capital structure

Conclusion

The weighted average cost of capital (WACC) refers to the weighted average of the cost of debt after taxes and the cost of equity.