In the previous article we review the concept of weighted average cost of capital and its formula. This video provides a detailed example of WACC calculation and also discusses some of the issues while using it. The video also discusses in detail the concept of marginal cost and why a firm can’t finance itself only from debt even though it looks cheaper.

**Estimating the Cost of Capital**

**Debt: **You will notice that the cost of debt is adjusted for tax (1-t) because in most countries the interest on debt is taken as a deduction to arrive at the taxable income. So, what’s taken into consideration is the after-tax cost of debt.

**Preferred Equity:** Estimating the cost of preferred equity is quite straight ward since the dividend is generally stated and fixed.

**Common Equity: **Estimating the cost of common equity is the most challenging among the three sources of capital. Cost of equity can be estimated using one of the two available methods: 1) using the CAPM model and 2) using the dividend discount model which is based on the discounted cash flows.

*In the next article we will look at how to determine the weights for each source of capital.*

## Leave a Reply