Description: The cost of capital is the blended cost of debt and equity that a company has acquired in order to fund its operations. It is important, because a company’s investment decisions related to new operations should always result in a return that exceeds its cost of capital – if not, then the company is not generating a return for its investors.
Formula: The cost of capital is comprised of the costs of debt, preferred stock, and common stock. The formula for the cost of capital is comprised of separate calculations for all three of these items, which must then be combined to derive the total cost of capital on a weighted average basis. To derive 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 of debt outstanding. The amount of debt outstanding that is used in the denominator should include any transactional fees associated with the acquisition of the debt, as well as any premiums or discounts on sale of the debt. These fees, premiums, or discounts should be gradually amortized over the life of the debt, so that the amount included in the denominator will decrease over time. The formula for the cost of debt is as follows:
(Interest Expense x (1 – Tax Rate)
Amount of Debt – Debt Acquisition Fees + Premium on Debt – Discount on Debt
The cost of preferred stock is a simpler calculation, since interest payments made on this form of funding are not tax-deductible. The formula is as follows:
Interest Expense
Amount of Preferred Stock
The calculation of the cost of common stock requires a different type of calculation. It is composed of three types of return: a risk-free return, an average rate of return to be expected from a typical broad-based group of stocks, and a differential return that is based on the risk of the specific stock in comparison to the larger group of stocks. The risk-free rate of return is derived from the return on a U.S. government security. The average rate of return can be derived from any large cluster of stocks, such as the Standard & Poor’s 500 or the Dow Jones Industrials. The return related to risk is called a stock’s beta; it is regularly calculated and published by several investment services for publicly-held companies, such as Value Line. A beta value of less than one indicates a level of rate-of-return risk that is lower than average, while a beta greater than one would indicate an increasing degree of risk in the rate of return. Given these components, the formula for the cost of common stock is as follows:
Risk-Free Return + (Beta x (Average Stock Return – Risk-Free Return))
Once all of these calculations have been made, they must be combined on a weighted average basis to derive the blended cost of capital for a company. We do this by multiplying the cost of each item by the amount of outstanding funding associated with it, as noted in the following table:
Total Debt Funding |
x |
Percentage Cost |
= |
Dollar Cost of Debt |
Total Preferred Stock Funding |
x |
Percentage Cost |
= |
Dollar Cost of Preferred Stock |
Total Common Funding |
x |
Percentage Cost |
= |
Dollar Cost of Common Stock |
= |
Total Cost of Capital |
Cautions: The dollar value of the preferred stock and common stock used in this calculation is based on the current market price of these items, rather than the price at which they were originally sold. By using the market rate, one can more accurately determine the assumed rate of return that investors are expecting at the moment; this is much preferable to using the book rate for either item, since this fixes the rate of return at the time when the shares were originally sold, and gives no indication of current market expectations.