Question

Please explain how a company computes their weighted average cost of capital, and why is it important? Compare the various components of the cost of capital, and include the tax advantages, if any, in the explanation.

Please include an explanation in your own words, and a good example.

Answer 1

Capital is the amount of money that the company requires to start a business. There are several ways by which this capital can be obtained. Some of the sources of capital are debt, equity, preferred stock and retained earnings. A company can use these sources of capital to finance their business. The company will assign certain weights to these sources of capital. There is a certain cost that is involved with these costs. For example: cost of debt, cost of equity, cost if preferred stock and cost of retained earnings. The weighted average cost of capital is the sum of the product of the weight and cost of each type of capital. It can be calculated by the following formula:

WACC = (weight of debt × cost of debt) + (weight of equity × cost of equity) + (weight of preferred stock × cost of preferred stock) + (weight of retained earnings × cost of retained earnings)