Topic 3.

1 – Calculating WACC

Computing the WACC—An Example

To compute a WACC, we need two things: the mix of the capital components in use and the cost of each
component.

1. Calculate the WACC for the Zodiac Company given the following information about its capital
structure.

Capital Component Value Cost

Debt 60,000 9%
Preferred Stock 50,000 11
Common Stock 90,000 14
200,000

SOLUTION: First we compute the capital structure weights on the basis of the dollar values given. This
involves adding up the dollar amounts and stating each as a percentage of the total. That calculation
results in the first two numerical columns below. The weight of the debt component, for example:

60,000 50,000 90,000

= .30 = 30% = .25 = 25% = .45 = 45%
200,000 200,000 200,000
Notice that the weights have to add up to 1.00 or 100%, and that they are the decimal equivalents of the
percentages in the firm’s capital structure.

Next multiply the cost of each component by its weight and sum the results as shown. The result is the
WACC.

Capital Component Value Weight Cost

Debt 60,000 .30 x 9% = 2.70%
Preferred stock 50,000 .25 x 11% = 2.75%
Common stock 90,000 .45 X 14% = 6.30%
200,000 1.00 WACC = 11.75%
Cost of Debt

To calculate the component cost of debt based on market returns, we take the return received by
investors currently purchasing the firm’s bonds and adjust it for the effects of taxes. Most debt isn’t
initially sold to the general public but is privately placed with large investors. Therefore, flotation costs
are minimal, and we need not adjust for them.

The market return on business debt is generally well known for the firm’s own securities or for issues of
similar risk. We will call that return kd. Then the cost of debt is

cost of debt = kd(1 - T)

where (1 - T) adjusts for the fact that interest is tax deductible to the paying firm.
2. Blackstone Inc. has 12% coupon rate bonds outstanding that yield 8% to investors buying them
now. Blackstone’s marginal tax rate including federal and state taxes is 37%. What is
Blackstone’s cost of debt?

SOLUTION: First notice that kd is the current market yield of 8%, not the coupon rate. To
calculate
the cost of debt we simply write ocst of debt equation and substitute from the information
given.

cost of debt = kd(1 - T)

= .08(1 - .37)

= 5.04%