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. Small Business

    Explaining Cost Of Capital

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

    Investors Need A Good WACC

    Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.
  3. Managing Wealth

    Weighted Average Cost Of Capital (WACC)

    Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality
  4. Investing

    Cost of Debt

    Cost of debt is the rate, expressed as a percentage, that a company pays on its borrowings.
  5. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  6. Investing

    How to Calculate Required Rate of Return

    The required rate of return is used by investors and corporations to evaluate investments. Find out how to calculate it.
  7. Investing

    What You Should Know About Preferred Stocks and Interest Rates

    These are the pros and cons of preferred stocks in a rising interest rate environment.
  8. Small Business

    Capital Structure

    Capital structure is the combination of the debt and equity a company uses to finance its long-term operations and growth.
  9. 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.
Frequently Asked Questions
  1. How can I avoid paying taxes on my Social Security income?

    Learn how to calculate the percentage of Social Security income benefits that may be taxable and discover strategies to reduce ...
  2. Can you pay off your Best Buy credit card in store?

    Learn how you can pay your BestBuy credit card in stores using cash or check. You can also pay by mail, online or over the ...
  3. How can you cancel your Walmart credit card?

    Learn how to close your Walmart credit card or Walmart MasterCard, and read details about the process of closing those credit ...
  4. Who is eligible for Canada Pension Plan benefits?

    Learn more about the Canada Pension Plan, who contributes to the plan and who can receive standard, disability, early retirement ...
Trading Center