Calculation of Component Cost of Common Equity

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The calculation of the Weighted Average Cost of Capital is as follows: {fraction of debt * [yield to maturity on outstanding long-term debt][1-combined state/federal income tax rate]} + {fraction of preferred stock * [annual dividend/net offering price]} + {fraction of common stock * cost of equity}. The cost of common equity can be calculated using three methods, the Capital Asset Pricing Model (CAPM), the Dividend-Yield-plus-Growth-Rate (or Discounted Cash Flow) approach, and the

Bond- Yield-plus-Risk-Premium approach. In this example, you are required to calculate the cost of equity using the Capital Asset Pricing Model (CAPM), which is illustrated as follows: {risk-free rate + beta(expected return on the market - risk-free rate)}. Using this model, the cost of common equity can be found as 16.48%.

The cost of perpetual preferred stock can be found by dividing the annual dividend by the net offering price, which is illustrated in this case as follows:

{$1.75/28.50) = 6.14%. The after-tax cost of debt can be found by taking the yield to maturity on the firm's outstanding long- term debt (9.5%), and multiplying this figure by (1 - annual tax rate 35%) = 6.175%. Incorporating all of these figures into the WACC equation gives a Weighted Average Cost of Capital of 10.807%