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. Economics

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  2. Investing Basics

    Breaking Down Optimal Capital Structure

    An optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
  3. Investing Basics

    Cost of Debt

    Cost of debt is the rate, expressed as a percentage, that a company pays on its borrowings.
  4. Bonds & Fixed Income

    A Primer On Preferred Stocks

    Offering both income and relative security, these uncommon shares may work for you.
  5. Investing

    McDonald's Stock: Capital Structure Analysis (MCD)

    Learn about the importance of capital structure, and what equity and debt capitalization measures can tell us about the performance of McDonald's Corporation.
  6. Economics

    What Are The Different Types Of Costs In Cost Accounting?

    Cost accounting measures several different types of costs associated with a company’s production processes.
  7. Credit & Loans

    Debt Ratios: Capitalization Ratio

    By Richard Loth (Contact | Biography)The capitalization ratio measures the debt component of a company's capital structure, or capitalization (i.e., the sum of long-term debt liabilities and ...
  8. Investing Basics

    What Determines Your Cost Basis?

    In any transaction between a buyer and seller, the initial price paid in an exchange for a product or service will qualify as the cost basis. When it comes to securities and related financial ...
  9. Professionals

    Top Things To Know For An Investment Banking Interview

    Without some basic knowledge, you won't get the job. Find out what you need to know and how to prepare.
  10. Trading Strategies

    What You Need To Know About Preferred Stock

    Curious about preferred shares? Here's what you should know about these bond-like instruments.
RELATED TERMS
  1. Composite Cost Of Capital

    A company's cost to borrow money given the proportional amounts ...
  2. Weighted Average Cost Of Capital ...

    Weighted average cost of capital (WACC) is a calculation of a ...
  3. Cost Of Debt

    The effective rate that a company pays on its current debt. This ...
  4. Cost Of Revenue

    The total cost of manufacturing and delivering a product or service. ...
  5. Capitalization Structure

    The proportion of debt and equity in the capital configuration ...
  6. Economic Spread

    1. A performance metric that is equal to the difference between ...
RELATED FAQS
  1. How do you calculate the ratio between debt and equity in the cost of capital

    Discover how to calculate the ratio between debt and equity when making cost of capital estimations using the weighted average ... Read Answer >>
  2. Do companies measure their cost of debt with before- or after-tax returns?

    Understand the before and after-tax calculations of cost of debt capital and how each is useful in deciding between funding ... Read Answer >>
  3. Which is more important when estimating cost of capital - debt or equity?

    Learn about the relative costs of debt and equity and how they affect the overall cost of capital, including why debt may ... Read Answer >>
  4. How do interest rates affect the weighted average cost of capital (WACC) calculation?

    The interest rate is one of many external factors that can change the inputs in the weighted average cost of capital (WACC) ... Read Answer >>
  5. What is the difference between the cost of capital and required return?

    Take a look at the primary conceptual differences between an investor's required rate of return and an issuing company's ... Read Answer >>
  6. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
Hot Definitions
  1. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  2. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  3. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  4. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  5. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  6. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
Trading Center