In our introduction to the weighted average cost of capital here, we introduced the function of the financial tool. In this article, we will attempt to break down the components of the WACC.
$E$ = market value of the firm’s equity
$D$ = market value of the firm’s debt
$\dfrac {E}{(D+E)}$ = percentage of financing that is equity
$\dfrac {D}{(D+E)}$ = percentage of financing that is debt
$T_c$ = corporate tax rate
- Cost of debt is the market interest rate of new debt that the firm can issue, not the coupon rate of the existing debt. Note that the after-tax cost of debt is used in WACC.
- Cost of preferred stock is calculated as Rps =preferred dividend / net issuing price of preferred stock.
- Cost of common stock is the required rate of return on the common stock, and is also called the cost of retained earnings. It can be derived using one of the following three methods:
- 1. The capital asset pricing model (CAPM) approach.
The equation is
Where Rf is the estimated risk-free rate; usually treasury rate is used.
β is the stock’s beta which is a measure of the stock’s risk
E(Rm) is the expected rate of return of the market.
- 2. The dividend discount model approach.
The equation is
Where D1 = next year’s dividend
P0 = current value of the stock
g = the expected constant growth rate of the firm. To estimate g is the most difficult part in this model, and it can be done by using the projected growth rate by security analysis or the estimate sustainable growth rate (link to the article on financial ratio).
- 3. Bond-Yield-Plus-Premium approach
Rcs can be estimated by adding a risk premium to the interest rate of the firm’s long-term debt. Rcs=long-term debt yield + risk premium
