Calculating the Weighted Average Cost of Capital

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In order to calculate the weighted-average cost of capital, the first step is to identify the total capital, and then place the different elements of the capital structure into either debt or equity, and in this case leases as well. Thus, Microsoft has a total of $3120 million in capital ($950 debt + $20 leases + $500 preferred + $900 common + $750 retained earnings). The preferred, common and retained earnings will all be treated as equity. This gives us the following weightings: 30.4% debt; 0.6% leases and 69% equity. The WACC for Microsoft is therefore as follows: (.304)(7) + (.006)(8) + (.69)(9) 2.128 + .048 + 6.21 = 8.386% If Microsoft wants to lower its cost of capital, then it needs to analyze the current cost of capital in relation to its desired cost of capital. The company's current weighted average cost of capital is 8.386% and the three components of this cost of capital have 7, 8 and 9% costs respectively. Thus, the only way to lower the cost of capital is to increase the amount of the 7% cost, which is debt. The following illustration will outline how increasing debt will lower the cost of capital at Microsoft. If some equity was converted to debt so that debt was now 50% of the capital structure at Microsoft, the company's weighted average cost of capital would be as follows: (.5)(7) + (.006)(8) + (.494)(9) = 3.5 + .048 + 4.446 = 7.994% As we can see, the cost of capital is now lower. Thus, in order to achieve a lower weighted average

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