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.