In the context of financial management, the term "cost of capital" refers to the

remuneration required by investors or lenders to induce them to provide funding

for an ongoing business. If the firm's goal is to remain profitable and to incr
ease value to its shareholders, any use of capital must return at least its cost
of capital, and optimally, an amount greater than its cost of capital. The Weig
hted Average Cost of Capital (WACC) is often used as a benchmark, or "hurdle rat
e" when evaluating new projects and businesses that would require use of the sca
rce resource of funding.
Computing a company's cost of capital is not as simple as using, for example, th
e rate of interest it is charged on bank financing. The true cost of capital mus
t be determined considering economic, market, and tax issues. Sometimes investor
relations and market perception play a role in determining a company's capital
structure as well.
Most firms do not rely on only one type of financing, but seek to maintain an ac
ceptable capital structure using a mix of various elements. These sources of fin
ancing include long-term debt, common stock, preferred stock, and retained earni
ngs. In this discussion we will examine the four types of capital, their relativ
e costs, and the methods by which a Weighted Average Cost of Capital is derived
for practical use.
COST OF LONG-TERM DEBT
The cost of long-term debt is the after-tax cost of borrowing through the issuan
ce of bonds. The proceeds of the bonds are reduced by the costs incurred to issu
e and sell the securities, called flotation costs. The following formula illustr
ates the computation of the before-tax cost of debt of a $1000 bond:
where I = Annual interest
P = Net proceeds of bond issue
n = Number of years to maturity
K d = Before-tax cost of debt
It is important to state the cost of financing on an after-tax basis because int
erest on debt is tax-deductible. The before-tax cost of debt can be converted to
the after-tax cost of debt by applying the following equation:
where T = the firm's corporate tax rate
K i = the after-tax cost of debt to the firm
COST OF COMMON STOCK EQUITY
The cost of common stock equity is estimated by determining the rate at which th
e investor discounts the expected dividends to determine the share value. That i
s, the amount an investor is willing to pay for a share of stock is determined b
y his view of the future dividends potential of the security. One method used to
determine the cost of common stock equity is the Constant Growth Valuation (Gor
don) Model. This model is based on the assumption that a share's value is based
on the present value of all future dividends in perpetuity. The following formul
a illustrates the model:
where K i = the cost of common stock equity
D 1 = the expected dividend for the next period
P o = the present value of future dividends
g = the expected percentage dividend growth rate in decimal form