Submitted By maneater56

Words 896

Pages 4

Words 896

Pages 4

A company has different sources of finance, namely common stock, retained earnings, preferred stock and debt. Weighted average cost of capital (WACC) is the average after tax cost of all the sources. It is calculated by multiplying the cost of each source of finance by the relevant weight and summing the products up.

Formula

For a company which has two sources of finance, namely equity and debt, WACC is calculated using the following formula:

Cost of equity is calculated using different models for example dividend growth model and capital asset pricing model.

Cost of debt is based on the yield to maturity of the relevant instruments. If no yield to maturity can be calculated we can base the estimate on the instrument's current yield, etc.

The weights are based on the target market values of the relevant components. But if no market values are available we base the weights on book values.

Cost of Preferred Stock

Cost of preferred stock is the rate of return required by the holders of a company's preferred stock. It is calculated by dividing the annual dividend payment on the preferred stock by the preferred stock's current market price.

In finance, the value of any asset equals the present value of its future net cash flows. In most cases, the cash flows stream of a preferred stock is a perpetuity because preferred stock has unlimited life and it pays a fixed amount of dividend each period. Value of a preferred stock is essentially the present value of the perpetuity. PV of Perpetuity = | Periodic Payment | | Discount Rate |

We can modify this relationship to come up with the formula for cost of preferred stock. The discount rate in the above relationship is the rate of return required by the holders of the preferred stock. The periodic payment is the fixed amount equal to the product of the stated percentage rate and the face value of the…...