Question

a company's capital structure is as follow: debt 39%; preferred stock 12%; common equity 49%. the after-tax cost of debt is 7.5%; the cost of preferred stock is 9%; and the cost of common equity is 12.5%. calculate the company's weighted average cost of capital

Answer 1

Answer:

WACC = 10.13%

Explanation:

Lets first understand what WACC is. WACC or weighted average cost of capital represents the total cost of financing. Now there are two main sources of long-term finance available to an entity, DEBT and EQUITY. Each source of finance has a different cost which highly depends upon the RISK PROFILE and RISK APPETITE of an entity. Some entities prefer debt financing over equity while some consider equity as more reliable source of finance.

When an entity takes finance from each source, it finds itself with a pool of funds which are then allocated based on priorities. WACC is the cost of the 'POOL OF FUNDS' (i.e an average cost of both debt and equity).

The formula of WACC is as follows:

WACC= ke×(E/V)+ Kp× (p/V) + kd×(d/V)

ke= cost of equity

E= market value of equity

kp= cost of preferred stock

V= combined value of debt and equity

kd= cost of debt

WACC = (7.5%×39÷100) + (12.5%×49÷100) + (9%× 12÷100)

WACC = 2.925 + 6.125 + 1.08

WACC = 10.13%