Principles of Managerial Finance

11 – 10 Why is the cost of financing a project with retained earnings less than the

cost of financing it with a new issue of common stock?

11.5 The Weighted Average Cost of Capital

Now that we have calculated the cost of specific sources of financing, we can

determine the overall cost of capital. As noted earlier, the weighted average cost

of capital (WACC),ka, reflects the expected average future cost of funds over the

long run. It is found by weighting the cost of each specific type of capital by its

proportion in the firm’s capital structure.

Calculating the Weighted Average

Cost of Capital (WACC)

Calculating the weighted average cost of capital (WACC) is straightforward:

Multiply the specific cost of each form of financing by its proportion in the firm’s

capital structure and sum the weighted values. As an equation, the weighted aver-

age cost of capital, ka, can be specified as follows:

ka(wiki)(wpkp)(wskr or n) (11.9)

where

wiproportion of long-term debt in capital structure

wpproportion of preferred stock in capital structure

wsproportion of common stock equity in capital structure

wi wp ws1.0

Three important points should be noted in Equation 11.9:

1. For computational convenience, it is best to convert the weights into decimal
   form and leave the specific costs in percentage terms.


2. The sum of the weights must equal 1.0.Simply stated, all capital structure
   components must be accounted for.


3. The firm’s common stock equity weight, ws, is multiplied by either the cost of
   retained earnings, kr, or the cost of new common stock, kn. Which cost is
   used depends on whether the firm’s common stock equity will be financed
   using retained earnings, kr, or new common stock, kn.

EXAMPLE In earlier examples, we found the costs of the various types of capital for Duchess

Corporation to be as follows:

Cost of debt, ki 5.6%

Cost of preferred stock, kp10.6%

Cost of retained earnings, kr13.0%

Cost of new common stock, kn14.0%

482 PART 4 Long-Term Financial Decisions

weighted average cost
of capital (WACC), ka
Reflects the expected average
future cost of funds over the long
run; found by weighting the cost
of each specific type of capital
by its proportion in the firm’s
capital structure.

LG4