Introduction to Finance

weighted average cost of capital 
(WACC) 
represents the minimum 
required rate of return on a capital 
budgeting project; it is found by 
multiplying the marginal cost of 
each capital structure component by 
its appropriate weight and summing 
the terms

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18.4 Weighted Average Cost of Capital
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market value of the fi rm’s stockholders’ equity divided by the market value of its assets. 
Calculated this way, bond and stock market price fl uctuations, as well as new issues and security 
repurchases, can move the fi rm toward or away from its target.
Financial theory favors the second method as most appropriate. Current 
market 
values are 
used to compute the various costs of fi nancing, so it is intuitive that 
market-
based costs should 
be weighted by 
market-
based weights.
The basic capital structure of a fi rm may include debt, preferred equity, and common 
equity. In practice, calculating the cost of these components is sometimes complicated by the 
existence of hybrid fi nancing structures (e.g., convertible debt) and other variations on straight 
debt, preferred equity, or common equity.
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A discussion of this advanced topic is beyond the 
scope of this book.
As an example, let’s compute the WACC for Eastnorth Manufacturing. Assume that East-
north Manufacturing has determined that its target capital structure should include one-third 
debt and two-thirds common equity. Eastnorth Manufacturing’s current after-tax cost of debt 
is 6.0 percent, and its current cost of retained earnings is 15.0 percent. What is Eastnorth 
Manufacturing’s WACC, assuming that last year’s operations generated suffi
cient retained 
earnings to fi nance this year’s capital budget? 
Since suffi
cient new retained earnings exist, Eastnorth Manufacturing will not need to 
issue shares to implement its capital budget. Thus, the cost of retained earnings will be used 
to estimate its weighted average cost of capital. The target capital structure is one-third debt 
and two-thirds common equity. Using equation 18-7, Eastnorth Manufacturing’s WACC is the 
following:
WACC = (1∕3) (6.0 percent) + (2∕3) (15.0 percent)
= 12.0 percent
Given current market conditions and Eastnorth Manufacturing’s target capital structure 
weights, the fi rm should use a discount rate of 12.0 percent when computing the NPV for 
average risk projects.
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To compare Eastnorth Manufacturing’s current capital structure with its target capital 
structure, let’s assume that Eastnorth Manufacturing has two bond issues outstanding. One is 
rated AA and has a YTM of 8.8 percent; the other is rated A and yields 9.5 percent. The fi rm 
also has preferred stock and common stock outstanding. The table below shows the current 
market prices and the number of shares or bonds outstanding. How does Eastnorth Manufac-
turing’s current capital structure compare to its target?