Cost of Capital

Ensuring that all investments of a firm yield a higher return than the cost of capital. Explanation of Cost of Capital.

What is Cost of Capital? Description

The Cost of Capital is the amount, expressed as an annual percentage, that a firm must pay to obtain adequate funds.

Firms finance their operations by three mechanisms:

1. Issuing stock (equity or preferred).

2. Issuing debt (borrowing from a bank) .

3. Reinvesting prior earnings (internal financing).

The significance to a business of its cost of capital is that it has to ensure that all investments it makes yield a Return, which is at least equal to the cost of capital. The return on capital must be greater than the cost of capital.

Calculation of Cost of Capital. Formula

The Cost of Capital is the weighted sum of the:

1. Cost of Debt

2. Cost of Preferred Stock

3. Cost of Equity

To derive the Cost of Capital, each of its 3 components must be calculated first.

To calculate the Cost of Debt, multiply the interest expense associated with the debt by the inverse of the tax rate percentage, and divide the result by the amount outstanding. Be sure to include any transactional fees in the denominator (acquisition fees, premiums, discounts).

To calculate the Cost of Preferred Stock, simply divide interest expense by the amount of preferred stock.

Visit  the following page for more details on calculating the Cost of Equity.

Now that all of its three components have been calculated, they can be combined on a weighted average basis to derive the blended cost of capital for a firm.

This is done by multiplying the cost of each component by the amount of outstanding funding associated with it (see figure 2):

Cost of Capital Special Interest Group

Visit the Special Interest Group

Cost of Capital Forum

Kunal Dhemre - India

Equity Analysis (Fundamental analysis)

"How to calculate a WACC for Infosys technology 2009 & what is the projected Balance sheet & Profit & Loss & Cash Flows for 2009 to 2013"

0

shraddha - India

Cost of retained earnings

"My question is how to calculate cost of capital in case a company has its funds only through equity shares & its reserves? Then how to calculate cost of retained earnings (reserves). As it is a major constituent of company's long term funds."

0

Comment on this Page

Cost of Capital Education & Events

Instead of the term (Weighted Average) Cost of Capital you often find its acronym: WACC.

Compare with Cost of Capital: Cost of Equity  |  WACC  |  Capital Asset Pricing Model  |  Internal Rate of Return

Return to Management Hub: Decision-making & Valuation  |  Finance & Investing

More Management Methods, Models and Theory