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:
Issuing stock (equity or preferred).
Issuing debt (borrowing from a bank) .
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:
Cost of Debt
Cost of Preferred Stock
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):
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Information Sources
Various sources of information regarding the Cost of Capital. Here you will find powerpoints, videos, news, etc. to use in your own lectures and workshops.
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