The weighted average cost of capital is used by business executives to calculate a firm's average cost of its financing sources. A company usually has to finance its assets through debt and equity. The percentages of debt and equity that make up a firm's total financing sources are determined and then multiplied by their respective total costs. The total weighted cost of capital is multiplied by the firm's corporate tax rate to arrive at the cost of capital. The weighted average cost of capital symbolizes the firm's required rate of return. It is used to make decisions regarding expansions and mergers. The firm's weighted average cost is also used as the required rate of return for determining the net present value of potential capital projects, such as the purchase of a new manufacturing facility.
Determine the firm's total cost of equity, its total cost of debt and its corporate tax rate. Calculate the firm's cost of equity by first dividing the dividends per share by the current market value of the stock and then adding the growth rate of dividends. Calculate the total cost of debt by consulting the firm's balance sheet for any bonds or loans payable.
Add the market value of both the firm's equity and the firm's debt. Label this figure as the total cost of capital. Divide the total cost of capital by the market value of equity. Label this figure as the percentage of the cost of equity. Multiply the cost of equity percentage by the total equity cost. Label this figure as the weighted cost of equity.
Divide the total cost of capital by the market value of the firm's debt. Label this figure as the percentage of the cost of debt. Multiply the cost of debt percentage by the total cost of debt. Label this figure as the weighted cost of debt.
Subtract one minus the corporate tax rate. Make sure to subtract the corporate tax rate as a percentage in decimal form. For example, if a firm's corporate tax rate is 30 percent, you would subtract .30 from 1.00 to arrive at a figure of .70. Multiply this figure by the weighted cost of debt. Add the weighted cost of equity to the figure obtained from the previous multiplication. Note that the final calculation gives the weighted average cost of capital or required return rate.
- Value Based Management: Weighted Average Cost of Capital
- "Financial Accounting"; Paul Kimmel; 2007
- Photo Credit Thomas Northcut/Photodisc/Getty Images
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