How to Reduce a Company WACC By Issuing Preferred Stock

Calculate your company's weighted average capital cost.

The WACC, or weighted average capital cost, is a weighted average of all of the interest rates at which a company borrows funds. Preferred stock can be used to reduce the WACC if it lowers the overall rate.

Instructions

1. Calculate the WACC. Look at the liabilities listed on the balance sheet. Each liability has an interest rate associated with it. Separate equity liabilities such as stocks from debt liabilities such as bonds. Add up all of the equity liabilities and divide each individual liability by the combined total of all liabilities to get the percentage weight for each one. Multiply each percentage weight by the interest rate to get a weighted rate. For debt, repeat this process, multiplying the weighted rate by 1 minus the company's tax rate as interest payments are tax-deductible. Add the weighted rate for equity to the weighted rate for debt to get the overall WACC.

2. Preferred stock pays dividends so its required rate of return is lower than common stock. Delay paying dividends on preferred stock if contract rules allow it. This is called dividends in arrears. The dividends in arrears, as well as the current year's dividends, must be paid to the preferred stockholders before a new dividend can be issued on common stock.

3. Lower the WACC by paying off loans early with preferred stock. Only pay off loans early if they have higher rates than the preferred stock, otherwise this will raise the WACC. Existing loans may have higher interest rates than a new issue of preferred stock. This can happen if the company borrowed money when the federal funds rate was higher and did not refinance the loans. This situation also occurs if the firm is considered a credit risk because of potential bankruptcy, according to Dr. Chad Zutter of Katz School of Business.

4. Issue preferred stock to change the debt-to-equity ratio. Loan contracts can have clauses raising their interest rates if the company borrows additional funds, and it will be more expensive to take on additional debt as the company's current debt load increases. Using large amounts of debt increases the risk that the company will not be able to pay back its loans. Banker Lee Estenson mentions more potential consequences: The lender may add spending restrictions on working capital, fixed asset maintenance and revolvements of equity. Because of these restrictions, the company must borrow at higher rates to accomplish these tasks unless it issues stock.

References

• Pitt: CZutter
• Year in Cooperation: A Cooperative Development Magazine: How a Banker Looks at Financial Leverage

Resources

• BQuest: Insights Into Operating and Financial Leverage