How do firms compute the weighted-average cost of capital? WACC = [ (D/V) (1-Tc) (r debt) + (E/V) (r equity) + (P/V) (r preferred)

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How do firms compute the weighted-average cost of capital? WACC = [ (D/V) (1-Tc) (r debt) + (E/V) (r equity) + (P/V) (r preferred)





Answer: The WACC is the expected rate of return on the portfolio of debt and equity securities issued by the firm. The required rate of return on each security is weighted by its proportion of the firm's total market value (not book value). Since interest payments reduce the firm's income tax bill, the required rate of return on debt is measured after tax, as (1-Tc)r debt.
This WACC formula is usually written assuming the firm's capital structure includes just two classes of securities: debt and equity. If there is another class, say preferred stock, the formula expands to include it. In other words, we would estimate r preferred, the rate of return demanded by preferred shareholders, determine P/V, the fraction of market value accounted for by preferred, and add r preferred X P/V to the equation. Of course the weights in the WACC formula always add up to 1.0
In this case, D/V + P/V + E/V = 1.0.

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