The following are the components of the cost of capital:

1. The Cost of Debt:

Debt financing is one of the more frequently sought forms because it is one
of the least costly. In terms of the cost of capital definition, the firm must
make sure that when it borrows funds, the rate earned through use of the
debt-invested funds is equal to or greater than the cost of this debt.

Thus, the cost of debt must be equal to the rate of return earned on debt-
invested funds, so that the earnings available to the common shareholder
remain unchanged. This means that the explicit component cost of debt is
equal to the rate of return earned by investors, or the interest rate on debt.

Thus the cost of capital is really a minimization concept in the sense that a
minimum rate of return that must be earned on invested rupees is specified.
Of course, a higher rate of return, above the cost factor to the firm, is much
more desirable. Initially we may define the cost of debt as the interest rate
the firm has to pay to the lending source, whether it be to a bank or for a
new debt issue the firm has placed with the public market.

This will be referred to as the cost of debt because this is what the firm has
to pay annually to its debt investors for borrowing the sum. The firm must
earn such a rate of return on its debt-financed investments that the earnings
available to the common shareholders remain unchanged.

If less than an estimated per cent return were received on the investment,
the earnings available to the shareholders (earnings per share) would
decline, and this could have an adverse effect on the price of the stock.

2. The Cost of Preferred Stock:

Preferred stock (or preference shares) is frequently referred to as a hybrid

security which is somewhere between debt and common equity. It is similar
to debt in that it pays a fixed commitment or annual dividend, and, in case
of liquidation, the claim to the assets of the corporation by preferred holders
has priority over the claims of the common shareholders.

It is similar to equity, or common stock, in that if the dividends are not paid,
the result is not corporate bankruptcy. To the investor, an investment in
preferred stock is less risky than one in the common stock of the
corporation, but more risky than an investment in its debt securities.

3. The Cost of Using Retained Earnings:

Equity capital usually consists of two components. The first is the amount
of funds available in the form of net income that may be used to pay
dividends or may be retained in the business for asset purchases. The second
source of equity capital is the amount of funds raised by a new common
stock issue.

The definition of the cost of retained earnings is the rate of return that must
be earned on equity-invested capital so that the total yield available to the
common shareholders remains unchanged. The cost of retained earnings
simplifies to the rate of return that stockholders expect to earn on the
common stock of the firm. This expected or required rate of return can be
determined from the valuation formula for common stock.

4. The Cost of Issuing New Equity Stock:

It will be found that the cost of issuing new common stock or external equity
is slightly higher than the cost of internal equity or retained earnings. This
is because the price that the stock is sold for in the market is not the price
the firm receives.

As with preferred stock, when new common stock is issued, firms utilize
the services of investment bankers to help place it; for their services, the
bankers are paid a commission, which is referred to as the flotation costs of
underwriting a new equity issue.

The price the firm is interested in to determine its cost of equity for a new
issue is the net price, which is the market price of the stock less the’ flotation
costs.