The weighted average cost of capital tells you how much of a return a company needs to make on an investment to make it worth the investment. For example, if you're starting a new company, you have to factor in the cost of debt, dividends to preferred shareholders and returns to the common shareholders. Preferred stock is in some ways a hybrid between debt and equity because it is not a loan, so the dividend payments aren't tax deductible, but isn't equity either because the value of the stock won't grow as the company grows. If the weighted average cost of capital isn't high enough, the project isn't worth investing in.
Calculate the portion of the company that is financed through debt, preferred stock and common stock equity. Divide the amount of each by the total to find each portion. For example, suppose a company has $5 million worth of debt, $1 million of preferred stock and $4 million of common stock equity. The company has 50 percent debt, 40 percent common stock equity and 10 percent preferred stock.
Calculate the after-tax cost of debt for the company by multiplying the interest rate times 1 minus the company's tax rate. For example, assume the company pays an average of 6 percent interest on its loans and its tax rate is 35 percent. Subtract 0.35 from 1 to get 0.65 and multiply 0.65 by 6 percent to find the after-tax cost of debt to be 3.9 percent.
Multiply the portion of the company comprised of debt by the after-tax cost of debt. In this example, multiply 3.9 percent by 0.5 to get 1.95 percent.
Multiply the interest rate on the preferred stock by the portion of the company comprised of preferred stock. In this example, if the company pays a 6.5 percent dividend, multiply 6.5 percent by 0.1 to get 0.65 percent.
Multiply the portion of the company comprised of equity by the required return on the common stock equity, also called the risk-adjusted discount rate. In this example, if the required return is 9 percent, multiply 9 percent by 0.4 to get 3.6 percent.
Add the results from calculating the weighted average cost of each portion to figure the total weighted average cost of capital. In this example, add 1.95 plus 0.65 plus 3.6 percent to find the weighted average cost of capital equals 6.2 percent.
- You can calculate the risk-adjusted discount rate by multiplying the company's beta times the market risk premium and adding the risk-free rate. The beta represents the risk of the particular company relative to the market as a whole. For example, if the company has a beta of 1.25, a market risk premium of 6 percent and the risk-free rate is 2 percent, multiply 6 by 1.25 to get 7.5 and then add 2 to get 9.5 percent.