Question

Please explain Cost of Capital and what is the formula to calculate.

Answer 1

Cost of capital of a firm refers to its WACC [Weighted average cost of capital]:

1] The first step in calculating WACC is to find the component cost of capital.

Component cost of capital is the cost of capital of the individual sources of funds like debt, preferred stock, retained earnings and common equity.

The component cost can be found as below:

Cost of debt:

Before tax cost of debt is the market rate of debt, usually referred to as the YTM in case of bonds.

After tax cost of debt = Before tax cost of debt*(1-tax rate).

Cost of preferred stock:

It is given by the formula:

Preferred dividend per share/Price per preferred share.

Cost of retained earnings and new common stock:This

The two popular methods used are the Dividend discount model and the CAPM.

DDM:

This is given by the formula:

Cost of retained earnings = D1/P0+g, where D1 = the next expected dividend, P0 = current price of the stock and g = expected growth rate in dividends.

For new equity the formula would be D1/(P0-flotation cost per share)+g

CAPM:

The cost of capital = risk free rate+beta*(expected market return-risk free return)

2] Calculation of WACC:

WACC as the name implies is the weighted average of the cost of the components of the capital structure.

It is given by the formula:

WACC = Cost of debt*weight of debt+Cost of preferred stock*weight of preferred stock+cost of retained earnings*weight of retained earnings+cost of new equity*weight of new equity.

The weights are the proportion of the source of capital in the capital structure. It should be based on the market values of the components.

Total capital would be market value of debt+market value of preferred stock+market value of retained earnings+market value of common equity.

The weight of each component would be:

Market value of the component/Total market value of the capital of the firm