Cost of Capital: Definition

 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.
o Opportunity cost refers to the value forgone in order to make one
particular investment instead of another.
o A rate of return is measure of profit as a percentage of investment.
 "Capital is a necessary factor of production and, like any other factor, it has a
cost,". In the case of debt capital, the cost is the interest rate that the firm must
pay in order to borrow funds. For equity capital, the cost is the returns that must
be paid to investors in the form of dividends and capital gains. Since the
amount of capital available is often limited, it is allocated among various
businesses on the basis of price. "
 For a company, the cost of capital is "a weighted average of the returns that
investors expect from the various debt and equity securities issued by the
firm,"
 Cost of capital is the required return necessary to make a capital budgeting project,
such as building a new factory, worthwhile. When analysts and investors discuss
the cost of capital, they typically mean the weighted average of a firm's cost of
debt and cost of equity blended together. The cost of capital metric is used by
companies internally to judge whether a capital project is worth the expenditure of
resources, and by investors who use it to determine whether an investment is
worth the risk compared to the return. Many companies use a combination of debt
and equity to finance their businesses and, for such companies, the overall cost of
capital is derived from the weighted average cost of all capital sources, widely
known as the weighted average cost of capital (WACC).
 The cost of capital is the weighted-average, after-tax cost of a corporation's long-term debt, preferred
stock (if any), and the stockholders' equity associated with common stock. It is expressed as a
percentage and it is often used to compute the net present value of the cash flows in a proposed
investment. It is also considered to be the minimum after-tax internal rate of return to be earned on
new investments.

Bibliography:

 Averkamp, H. (n.d.). What is the cost of capital. Retrieved December 9, 2019 from:
https://www.accountingcoach.com/blog/what-is-the-cost-of-capital
 Brigham, E. F. & Houston, J.F. (2009). Fundamentals of Financial Management. Florida, USA.
South-Western Cengage Learning
 Brealey, R.A.& Myers, S.C. (
 Cost of Capital. (2019, October 7). Retrieved December 9, 2019, from
https://investinganswers.com/dictionary/c/cost-capital.
 Kenton, W. (2019, June 5). Retrieved December 9, 2019, from
https://www.investopedia.com/terms/c/costofcapital.asp
  Cost of Capital Formula (n.d.) Retrieved December 9, 2019 from:
https://www.wallstreetmojo.com/cost-of-capital-formula/
 Obaidullah, J. (2019). Cost of Capital. Retrieved December 9, 2019 from:
https://xplaind.com/424047/cost-of-capital

Formula:

1. To get Weightage of Debt=

Weightage of debt = Amount of outstanding debt ÷ Total capital

Total capital = Amount of outstanding debt + Amount of Preference share + Market value of
common equity

2. Find the Cost of Debt= Interest Expense * (1 – Tax Rate) ÷ Amount of outstanding debt

3. Find the Weightage of Preference Share = Amount of preference share ÷ Total capital

4. Find the Cost of Preferred Stock= Dividend on preference share ÷

Amount of Preferred Stock
5. Find the Weightage of Equity= Market value of common equity ÷
Total capital
6. Cost of Equity = Risk-Free Return + Beta * (Average Stock Return – Risk-Free
Return)

Weighted average cost of capital is calculated by multiplying the after-tax cost of debt with the
percentage of debt in total capital, multiplying the cost of preferred stock with the percentage of preferred
stock in total capital, multiplying the cost of common stock with the percentage of common stock in total
capital and summing all the products together.

The following equation mathematically expresses the definition of WACC:

Cost of Capital = wd × rd × (1 - t) + wp × rp + we × re

Where wd, wp and we refer to the relative percentage of debt, preferred stock and common stock in the
total target capital. rd, rp and re are cost of debt, cost of preferred stock and cost of common stock
respectively. rd is multiplied by (1 – t), where t refers to the tax rate, because interest expense is allowed
as deduction while calculating taxes and this tax-deductibility creates a saving which must be accounted
for.
 Cost of Capital Formula (n.d.) Retrieved December 9, 2019 from:
https://www.wallstreetmojo.com/cost-of-capital-formula/
 Obaidullah, J. (2019). Cost of Capital. Retrieved December 9, 2019 from:
https://xplaind.com/424047/cost-of-capital