How do I Compute Weighted Average Cost of Capital With Preferred Stock?

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Figuring in preferred stock when caculating WACC requires only a small modification.
Figuring in preferred stock when caculating WACC requires only a small modification. (Image: Chart analysis image by Dmitriy Lesnyak from Fotolia.com)

The weighted average cost of capital ("WACC") is a basic concept involved in the financial analysis of firms and capital-investment projects. WACC, which is a measurement of a company's cost of financing for its assets, most basically consists of equity and debt financing. However, many firms employ a third source of financing: preferred stock. If you can calculate WACC with equity and debt financing, calculating with preferred stock requires only a small modification to the formula.

Things You'll Need

  • Amount of debt the firm carries
  • Value of the firm's common equity outstanding
  • Amount of preferred stock the firm has issued
  • Weighted average interest cost of the firm's debt financing (as a percentage)
  • Expected rate of return on the firm's equity (as a percentage)
  • Dividend rate on the firm's preferred stock (as a percentage)
  • The firm's tax rate

Computation

Compute the value of the firm's total financing by adding (1) the amount of debt the firm carries, (2) the value of the firm's common equity outstanding, and (3) the amount of preferred stock the firm has issued by the firm.

Divide the amount of debt the firm carries by the value of the firm's total financing and multiply by the weighted average interest cost of the firm's debt financing (as a percentage).

Multiply the value in Step 2 by 1 minus the firm's tax rate. For example, if the firm's tax rate is 0.35, or 35%, multiply the value in Step 2 by 65%. The resulting value is the firm's debt-weighted average contribution to the cost of capital.

Divide the value of the firm's common equity outstanding by the value of its total financing and multiply by the expected rate of return on the firm's equity (as a percentage). The resulting value is the firm's equity-weighted average contribution to the cost of capital.

Divide the amount of preferred stock the firm has issued by the value of the its total financing, and multiply by the dividend rate on the its preferred stock (as a percentage). The resulting value is the firm's preferred-stock weighted-average contribution to the cost of capital.

Add the values in steps 3, 4 and 5. This is the firm's weighted average cost of capital.

Tips & Warnings

  • There is no adjustment for income taxes, since preferred-stock dividends are paid after the distribution of such taxes.

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References

  • "Fundamentals of Corporate Finance"; Jordan Bradford, Randolph Westerfield, Stephen A. Ross; 2009
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