Corporate Finance - The Cost of Capital

The following sections discuss the cost of capital in terms of its components, calculations, and company internal targets. Readers should know the costs that make up the weighted cost of capital (WACC).

Interpreting the Cost of Capital
Given the importance of capital budgeting, a company should use the weighted average of the costs of the various types of capital it may use in financing its operations.

A company uses debt, common equity and preferred equity to fund new projects, typically in large sums. In the long run, companies typically adhere to target weights for each of the sources of funding. When a capital budgeting decision is being made, it is important to keep in mind how the capital structure may be affected.

Cost Components
A company's weighted average cost of capital (WACC) is comprised of the following costs:
1.Cost of debt
2.Cost of preferred stock
3.Cost of retained earnings
4.Cost of external equity

1. Cost of Debt
In the WACC calculation, the after-tax cost of debt is used. Using the after-tax cost takes into account the tax savings from the tax-deductibility of interest.


The after-tax cost of debt can be calculated as follows:

Formula 11.1

After-tax cost of debt = kd (1-t)


Look Out!
It is important to note that kd represents thecost to issue new debt, not the firm\'s existing debt.
Example: Cost of Debt
Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is 40%. What is Newco's cost of debt?

Answer:

kd (1-t) = 7% (1-0.40) = 4.2%


2. Cost of Preferred Stock
Cost of preferred stock (kps) can be calculated as follows:

Formula 11.2
kps = Dps/Pnet

where:
Dps = preferred dividends
Pnet = net issuing price

Example: Cost of preferred stock
Assume Newco's preferred stock pays a dividend of $2 per share and it sells for $100 per share. If the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock?

Answer:
kps = Dps/Pnet = $2/$100(1-0.04) = 2.1%

Cost of Retained Earnings
Related Articles
  1. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  2. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  3. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  4. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  5. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  6. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  7. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  8. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
  9. Professionals

    How to Improve Your Cash Flow in Manufacturing

    Here are 10 ways to to improve a manufacturer's cash flow.
  10. Professionals

    10 Ways to Improve Cash Flow in Construction

    Improving cash flow in construction requires some sector-specific strategies.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!