Cost of Capital

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

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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.


Cost of Debt calculation + Cost of Preferred Stock calculation


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


Calculation Cost of Equity, Formula


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 calculation


Cost of Capital Forum
  How Inflation Affects Cost of Capital and Profitability
Inflation has positive effects in the liabilities side of the balance sheet, as it diminishes the present value of monetary liabilities such as long term loans.
Nevertheless, this advantage does not usually fully compensate the negative effects ...
     
 
  Analysis of Capital Investments
Should a firm accept the independent projects described below? Why or why not?
A) the firmīs cost of capital is 10 % and the estimated internal rate of return of the project is 11 %.
B) a capital investment requires a $150,000 initia...
     
 
  Cost of Capital ( Equity Only)
We recently were required to calculate a charge in order to determine the economic value added. We used CAPM to calculate the cost of equity. We are a debt free company. Since we are not a listed company so we took the beta of the comparable listed c...
     
 
  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....
     
 

Cost of Capital Special Interest Group


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Cost of Capital Education & Events


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Best Practices - Cost of Capital Premium

Expert Tips - Cost of Capital Premium
 

Cost of Capital Usage

The cost of capital is applied for Capital Budgeting objectives. Under the Net Present Value...
Usage (application): Cost of Capital application
 
 

Resources - Cost of Capital Premium

Introduction and Calculation of WACC and its Components

Establishes an initial understanding of:
- Cost of Capital
- Cost of Equity
- Cost of Debt
- WACC
Includes calculation with c...
Usage (application): Initial Understanding and Calculation of WACC and Cost of Capital, Trainings, Workshops
 

Corporate Valuation for Businesses

Presentation that elaborates on corporate valuation, including the following sections:
1. Three types of value:
- Book Value
- Market V...
Usage (application): Corporate Valuation, Book Value, Market Value, Intrinsic Value, Fundamental Value, M&A, VBM, Fundamental Investing
 

Introduction and Summary of Interest Rate Swap

Explanation of Base Rate Swaps.
A swap is an instrument that allows you to exchange a variable rate of a loan (that is linked to the base rate) f...
Usage (application): Initial Understanding of Interest Rate Swap
 

Cost of Capital Diagrams

Download and edit this 12manage PowerPoint graphic for limited personal, educational and business use. Republishing in intranets, websites, books, ma...
Usage (application): Capital Budgeting
 
 

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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


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