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