Computation of Cost of Capital

Computation of the cost of capital involves calculating the weighted average cost of the various sources of capital used by a company. The cost of capital is a crucial metric in corporate finance as it represents the return investors require for providing funds to the company.

1. Cost of Debt:

The cost of debt is the interest rate a company pays on its debt. It is relatively straightforward to calculate:

Cost of Debt = Annual Interest / Expense Total Debt​

Alternatively, you can use the following formula, taking into account the tax shield from interest payments:

Cost of Debt = Coupon Payment × (1−Tax Rate)

2. Cost of Equity:

The cost of equity is the return required by investors for holding the company’s stock. The most common methods to calculate the cost of equity are the Dividend Discount Model (DDM) and the Capital Asset Pricing Model (CAPM):

• Dividend Discount Model (DDM):

Cost of Equity = [Dividends per Share / Current Stock Price] + Growth Rate of Dividends

• Capital Asset Pricing Model (CAPM):

Cost of Equity = Risk – Free Rate + [Beta × (Market Return − RiskFree Rate)]

3. Cost of Preferred Stock:

The cost of preferred stock is the dividend paid on preferred stock:

Cost of Preferred Stock = Dividends per Share / Net Preferred Stock Price​

4. Weighted Average Cost of Capital (WACC):

Once you have calculated the costs of debt, equity, and preferred stock, you can calculate the WACC by weighting these costs based on their proportion in the company’s capital structure:

WACC = (Weight of Debt × Cost of Debt) + (Weight of Equity × Cost of Equity) + (Weight of Preferred Stock × Cost of Preferred Stock)

Where:

• The weights are typically expressed as the proportion of each component to the total capital structure.

Weight of Debt = Market Value of Debt / Total Market Value of Firm’s Capital​

Weight of Equity = Market Value of Equity / Total Market Value of Firm’s Capital​

Weight of Preferred Stock = Market Value of Preferred Stock / Total Market Value of Firm’s Capital

The WACC represents the average cost of all capital sources and is used as a discount rate in capital budgeting and valuation analyses.

Important Considerations:

• Market Values:

Use market values rather than book values for equity, debt, and preferred stock to reflect the true economic costs.

• Tax Shield:

Consider the tax shield on interest payments when calculating the cost of debt.

• Consistency:

Ensure consistency in the units of measurement (e.g., market values, dividends, and stock prices).

• Risk-Free Rate:

The risk-free rate in the CAPM should match the time horizon of the project being evaluated.

• Beta:

Beta is a measure of a stock’s volatility compared to the market and reflects the company’s systematic risk.

• Growth Rate:

The growth rate in the DDM represents the expected growth rate of dividends.