Cost of Capital

Knowledge Center

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):

Special Interest Group - Cost of Capital Special Interest Group (80 members)

Forum - Cost of Capital   Here you will find interesting and educational discussions.   Analysis of Capital Investments (1 reactions) Should a firm accept the independent projects described b...           How Inflation Affects Cost of Capital and Profitability Inflation has positive effects in the liabilities side of th...           Cost of retained earnings (1 reactions) My question is how to calculate cost of capital in case a co...           Cost of Capital ( Equity Only) We recently were required to calculate a charge in order to ...

Best Practices - Cost of Capital Here you will find the most valuable ideas.

Expert Tips - Cost of Capital Here you will find high-quality advice from experts.   Cost of Capital Usage Cost of Capital application...

Resources - Cost of Capital Here you will find powerpoint presentations, micro-learning videos and further information sources. Introduction and Calculation of WACC and its Components Initial Understanding and Calculation of WACC and Cost of Capital, Trainings, Workshops...   Corporate Valuation for Businesses Corporate Valuation, Book Value, Market Value, Intrinsic Value, Fundamental Value, M&A, VBM, Fundamental Investing...   Introduction and Summary of Interest Rate Swap Initial Understanding of Interest Rate Swap...   Cost of Capital Diagrams Capital Budgeting...     News about Cost Of Capital Method         News about Cost Of Capital Calculation         Videos about Cost Of Capital Method         Videos about Cost Of Capital Calculation         Presentations about Cost Of Capital Method         Presentations about Cost Of Capital Calculation         Books about Cost Of Capital Method         Books about Cost Of Capital Calculation         More about Cost Of Capital Method         More about Cost Of Capital Calculation

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