Cost of Capital
By Trevor Forde - Course Coordinator
Foundations of Financial Management MGMT 1916
What is Cost of Capital?
Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return
that could have been earned by putting the same money into a different investment with equal risk.
Thus, the cost of capital is the rate of return required to persuade the investor to make a given
investment.
Cost of capital is determined by the market and represents the degree of perceived risk by investors.
When given the choice between two investments of equal risk, investors will generally choose the one
providing the higher return.
Let's assume Company XYZ is considering whether to renovate its warehouse systems. The renovation
will cost $50 million and is expected to save $10 million per year over the next 5 years. There is some
risk that the renovation will not save Company XYZ a full $10 million per year. Alternatively, Company
XYZ could use the $50 million to buy equally risky 5-year bonds in ABC Co., which return 12% per year.
Because the renovation is expected to return 20% per year ($10,000,000 / $50,000,000), the
renovation is a good use of capital, because the 20% return exceeds the 12% required return XYZ
could have gotten by taking the same risk elsewhere.
The return an investor receives on a company security is the cost of that security to the company that
issued it. A company's overall cost of capital is a mixture of returns needed to compensate all creditors
and stockholders. This is often called the Weighted Average Cost of Capital (WCC) of the
company’s debt and equity.
Why It Matters:
Cost of capital is an important component of business valuation work. Because an investor expects his
or her investment to grow by at least the cost of capital, cost of capital can be used as a discount rate
to calculate the fair value of an investment’s cash flows.
Investors frequently borrow money to make investments, and analysts commonly make the mistake of
equating cost of capital with the interest rate on that money. It is important to remember that cost of
capital is not dependent upon how and where the capital was raised. Put another way, cost of capital is
dependent on the use of funds, not the source of funds.
Companies raise money from a variety of sources: (1) short-term sources such as accounts payable,
bank loans, and commercial paper, and (2) long-term sources such as bonds, preferred stock, retained
earnings, and sale of stock. When companies invest this money (in the companies’ assets), they
obviously want to earn at least the average cost of raising the funds. In other words, it would be foolish
to raise money at an average cost of 7% and then invest that money in the company to earn less than
7%. In other words, the cost of raising the money, called the cost of capital, becomes the minimum
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desired rate of return for investing the money. If the cost of capital is 8.5%, then the minimum desired
rate of return for investing the money is 8.5%.
However, while it might be interesting to calculate the average cost of raising money from all these
sources, it may not be very useful. This is because companies rarely finance their assets by raising
money across the board from all these sources.
However, companies do follow the matching principle, which says that short-term assets should be
financed with short-term liabilities and long-term assets should be financed with long-term
sources. While we might be able to survive a mistake in purchasing short-term assets, mistakes in
purchasing long-term assets stay with us much longer and are more expensive. Therefore, we want to
ensure that fixed assets earn at least the cost of financing them. If we want to avoid making a major
mistake like this, it is particularly important that we calculate accurately the cost of capital raised from
long-term sources. The most accurate term for this would be "the cost of long-term capital" but it is
generally shortened to the term "cost of capital."
How to Calculate the Cost of Capital
The cost of capital is simply a weighted average of the cost of the individual sources (i.e., bonds,
preferred stock, retained earnings, and sale of new common stock). For example, assume that you
raise 40% of your money in the form of debt, 20% in preferred stock, and 40% in common
equity. Given the cost of each shown in the table below, the weighted cost of capital for the company
would be 7.0%.
Proportion * Cost = Wt. Cost
0.40 * 5% = 2.0%
0.20 * 7% = 1.4%
0.40 * 9% = 3.6%
Cost of Capital = 7.0%
Let’s look at a few details for calculating the cost of each component.
Cost of Debt
Debt is special in the sense that its interest payments are tax-deductible. While this is a good thing, it
does present a problem when comparing its cost with the cost of the other components, whose costs
are not tax-deductible. So what is the solution? Simply place the cost of debt on an after-tax basis –
the same basis as the other sources. We do this by simply multiplying the interest rate times [1 - the
tax rate]. For example, if a company pays an interest rate of 8% and is in the 40% tax bracket,
the after-tax cost of debt would be:
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Cost of debt = interest rate * (1 – tax rate)
Cost of debt =
Cost of debt =
8%
* (1 – 0.40)
4.8%
Cost of Preferred Stock
The cost of money raised by selling preferred stock is, generically, the dollar cost divided by the
amount of money raised. If a company sells $1 million worth of preferred stock, pays the investment
banker $100,000 for its help with the sale, and pays $70,000 in annual preferred stock dividends,
the cost of preferred stock is equal to:
Cost of preferred stock =
preferred stock dividends
net proceeds from sale of preferred stock
Cost of preferred stock =
preferred stock dividends
preferred stock - flotation cost
Cost of preferred stock =
$70,000
$1,000,000 - $100,000
Cost of preferred stock =
7.78%
Cost of Retained Earnings
Stockholders let the company’s management keep some of the earnings and reinvest them back into
the company (rather than paying it to them in the form of dividends). This does not mean that these
retained earnings are free however – the stockholders still expect to earn a rate of return on the
company’s investment of this money. The rate of return that the company must earn on the investment
of this money (in order to keep the shareholders happy) is called the cost of retained earnings. The
formula for calculating the cost of retained earnings is shown below:
Cost of retained earnings =
next year's dividend
price of common
stock
Cost of retained earnings =
$2.00
$100.00
+ 9.00%
Cost of retained earnings =
2.00%
+ 9.00%
Cost of retained earnings =
11.00%
+ future growth rate of dividends
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Cost of New Equity
The cost of raising money through the sale of new common stock is the same as the cost of retained
earnings, with one exception: flotation costs. Money earned in the company’s operations (i.e., retained
earnings) is readily available without paying any outside agency; money raised from outside the
company often comes with commissions and fees (i.e., flotation fees) attached. The formula for
the cost of new common equity is as follows:
next year's dividend
Cost of new equity =
price of common stock x (1 - %
flotation cost)
+ future growth rate of dividends
$2.00
Cost of new equity =
$100.00 x (1 - 20%)
Cost of new equity =
Cost of new equity =
$2.00
$100.00 x 80%
$2.00
$80.00
Cost of new equity =
2.50%
Cost of new equity =
11.50%
+ 9.00%
+ 9.00%
+ 9.00%
+ 9.00%
Weighted Marginal Cost of Capital
Assume that Genuine Products, Inc. is raising money for expansion of its operation. It has part of the
money already set aside in the form of cash from this year's addition to retained earnings. In order to
stay at its optimal capital structure, it has decided to raise the money in the following proportions: 40%
debt, 10% preferred stock, 20% retained earnings, and 30% from the sale of new common
stock. Assuming that the company can raise money at the costs calculated above, the company's
marginal cost of capital will be:
Proportion * Cost
= Wt. Cost
0.40 * 4.80% = 1.92%
0.10 * 7.78% = 0.78%
0.20 * 11.00% = 2.20%
0.30 * 11.50% = 3.45%
Cost of capital = 8.35%
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