The capital budgeting process involves discounted cash flow analysis.

To conduct such
analysis, you must know the firm's proper discount rate. This discount rate is the firm's weighted
average cost of capital (WACC) and is also referred to as the marginal cost of capital (MCC).

On the right (liability) side of a firm's balance sheet, we have debt, preferred stock, and common
equity. These are normally referred to as the capital components of the firm. Any increase in a
firm's total assets will have to be financed through an increase in at least one of these capital
accounts. The cost of each of these components is called the component cost of capital.

Following are the capital components and their component costs:

kd The rate at which the firm can issue new debt. This is the yield to maturity on
existing debt. This is also called the before-tax component cost of debt.
kd(l -t) The after-tax cost of debt. Here, t is the firm's marginal tax rate. The after-tax
component cost of debt, kd(l -t), is used to calculate the WACC.
kps The cost of preferred stock. Found using following formula:

kce The cost of common equity. It is the required rate of return on common stock and
is generally difficult to estimate.
Found using following formula:

Since we are interested in the after-tax cost of capital, we adjust the cost of debt, kd, for the
firm's marginal tax rate, t. Since there is typically no tax deduction allowed for payments to
common or preferred stockholders, there is no equivalent deduction to kce or kps.

The weights in the calculation of a firm's WACC are the proportions of each source of capital in
a firm's capital structure.
The WACC is given by:

where:
wd =the percentage of debt in the capital structure
wps =the percentage of preferred stock in the capital structure
Wee = the percentage of common stock in the capital structure

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used
internally by company directors to determine the economic feasibility of expansionary
opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that
is similar to that of the overall firm.

Submitted by:

Nikhil Prabhakar
Tarunjyot Singh

Ankit Gangwar

Ipshita

Prachi Bansal

Mohit Rodeja

Daya Shankar

Sukhmani Grewal

Nakul Randev