Question

Explain what the main components of the cost of capital are. How do you calculate these components?

Answer 1

The main components of cost of capital are a) cost of equity b) cost of debt and c) cost of preferential capital. Following are the methods used for calculating individual components:

1. Cost of equity: Cost of equity is generally calculated using Capital Asset Pricing Model or CAPM, which is given below:

Required (or expected) Return = Risk Free Rate + (Market Return – Risk Free Rate)*Beta

1. Cost of Debt: cost of debt is the interest paid on these securities. However, it is important to take into account the tax impact of such interest, as the interest is tax deductible. For example, Debt of $100 at 5% when tax rate is 40% will have cost of

            =          Interest rate (1- tax rate)

            =          5% (1- 40%)

            =          3%

1. Cost of Preference Capital = It is the rate of interest payable on such capital. However, such interest or dividend is not tax deductible. For example, the cost of 5% preference capital is 5%

Weighted average cost of capital: Following formula is used for the purpose of calculating weighted average cost of capital

WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

E = Market value of the company's equity

D = Market value of the company's debt

V = Total Market Value of the company (E + D)

Re = Cost of Equity

Rd = Cost of Debt

T= Tax Rate