FIN-515- Managerial Finance Week 4_The Cost of Capital_Discussion_Question_2_Answer

Apr 24th, 2015
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FIN-515- Managerial Finance Week 4_The Cost of Capital_Discussion_Question_2_Answer

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The Cost of Capital (graded) What are possible capital components in the WACC equation? How does a company with debt, preferred stock, and common stock in its target capital structure calculate its weighted average cost of capital (WACC)? WACC = wd rd(1-T) + wp rp + wcrs rd=marginal debt capitalrp=marginal preferred stockrs=marginal cost of common equity using retained earnings The weighted average cost of capital (WACC) is calculated using the following formula: WACC = wdrd(1 - T) + wpsrps + wsrs, where wd is the percent of debt, rd is the interest rate on the firm's new debt, T is the firm's marginal tax rate, wps is the percent of preferred stock, rps is the yield investors expect on the preferred stock, ws is the percent of common equity (common stock), and rs is the rate of return investors expect from the firm's common stock. The proportions of debt, preferred stock and common equity typically used in the formula are the target proportions to eliminate slight variability due to slight actual differences from the target proportions. How is the weighted average cost of capital (WACC) used in a capital investment program to select investments?The weighted average cost of capital (WACC) is a tool used to decide whether or not to invest. It represents the minimum rate of return at which a company produces value for its investors. If the companies return is more than the WACC than for each dollar the company invests it is creating value. Conversely if the compa

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