310 Part 4 Investing in Long-Term Assets: Capital Budgeting
The target proportions of debt (wd), preferred stock (wp), and common equity
(wc), along with the costs of those components, are used to calculate the! rm’s
weighted average cost of capital, WACC. We assume at this point that all new
common equity is raised as retained earnings, as is true for most companies; hence,
the cost of common equity is rs.WACC!
(%
of^
debt
)
(After-tax
cost of^
debt
)"
(% of
pr eferred
stock
)
(Cost of
pr eferred
stock
)"
(% of
common
equity
)
(Cost of
common
equity
)10-1! wdrd(1 # T) " wprp " wcrsNote that only debt has a tax adjustment factor, (1 – T). As discussed in the next
section, this is because interest on debt is tax-deductible but preferred dividends
and the returns on common stock (dividends and capital gains) are not.
These de! nitions and concepts are discussed in the remainder of the chapter,
using Allied Foods for illustrative purposes. Later in the capital structure chapter,
we extend the discussion to show how the optimal mix of securities minimizes the
! rm’s cost of capital and maximizes its value.Weighted Average Cost
of Capital (WACC)
A weighted average of the
component costs of debt,
preferred stock, and
common equity.
Weighted Average Cost
of Capital (WACC)
A weighted average of the
component costs of debt,
preferred stock, and
common equity.
wd, wp, ws, we! target weights of debt, preferred stock, retained earnings (inter-
nal equity), and new common stock (external equity). The
weights are the percentages of the different types of capital the
! rm plans to use when it raises capital in the future. Target
weights may differ from actual current weights.^5
WACC! the! rm’s weighted average, or overall, cost of capital.(^5) We should also note that the weights could be based on the book values of the capital components or on their
market values. The market value of the equity is found by multiplying the stock’s price by the number of shares
outstanding. Market value weights are theoretically superior; but accountants show assets on a book-value basis,
bond rating agencies and security analysts generally focus on book values, and market value weights are quite
unstable because stock prices # uctuate widely. If a $ rm’s book and market values di! er widely, the $ rm may set
its target weights as a blend of book and market weights. We will discuss this at greater length in the capital
structure chapter; but for now, just take the target weights provided in this chapter as management determined.
SEL
F^ TEST Identify the! rm’s three major capital structure components and give their
respective component cost and weight symbols.
Why might there be two di" erent component costs for common equity?
Which one is generally relevant, and for what type of! rm is the second one
likely to be relevant?
If a! rm now has a debt ratio of 50% but plans to! nance with only 40% debt
in the future, what should it use as wd when it calculates its WACC?
10-3 COST OF DEBT, r
d
! 1 # T"
The interest rate a! rm must pay on its new debt is de! ned as its before-tax cost
of debt, rd. Firms can estimate rd by asking their bankers what it will cost to
borrow or by! nding the yield to maturity (or yield to call if the debt is likely
Before-Tax Cost
of Debt, rd
The interest rate the firm
must pay on new debt.
Before-Tax Cost
of Debt, rd
The interest rate the firm
must pay on new debt.