Sources of Capital

The cost of capital is the expected rate of return required to attract funds to a particular
investment. The word “capital” in “cost of capital” refers to the components of an entity’s
capital structure. The capital structure is a function of how the entity raises capital to fund
its business operations (i.e., the funding sources). Businesses typically raise capital by
issuing (i) common equity, (ii) preferred equity, and/or (iii) debt. 1,2
The capital structure can include a combination of these three components, each of which
has its own cost of capital. 3 When valuing the overall business enterprise, these three
types of cost of capital are “blended” together to form a “weighted average cost of capital”,
or WACC.

The basic forms of cost of capital when referring to an entity’s capital structure are defined
as follows:

• Common equity capital: The cost of equity capital is the expected return to
common equity (i.e., stock) investors. Often referred to as simply the cost of equity.
Common stocks are the most widely held form of equity, and thus the most familiar
type of equity investment for most people. Common stock owners hope to gain
from rising share prices, and from dividend distributions. Dividends to common
equity investors are typically paid after dividends to preferred equity investors have
already been paid. Also, common equity investors are typically “last in line” in the
case of liquidation or bankruptcy. Common equity is generally riskier than either
preferred equity or debt instruments, but over the long term may provide a higher
return. (Note that the higher the risk of an investment, the higher the expected
return.)
• Preferred equity capital: The cost of preferred equity capital is the expected
return to preferred equity (i.e., stock) investors. Usually referred to as simply the
cost of preferred equity. Preferred shares often pay a fixed dividend, and this
dividend is typically paid prior to any dividend payments to common equity
shareholders. Because the preferred equity’s dividend is often fixed, it often trades
like a bond with a coupon and its price will fluctuate (inversely) with market interest
rates. 4 However, certain forms of preferred stock (e.g., convertible preferred) have
features that resemble common equity. Preferred equity is generally less risky than

1
There may be more than one subcategory in any or all of the listed categories of capital. Also, there may be related forms of capital,
such as warrants or options.
2
Equity securities are generically referred to as “stocks”, and debt securities are generically referred to as “bonds”.
3
The cost of raising capital should include the costs of raising capital from external capital sources. These costs, commonly termed
flotation or transaction costs, reduce the actual proceeds received by the firm. Some of these are direct out-of-pocket outlays, such
as fees paid to underwriters, legal expenses, and prospectus preparation costs. Because of this reduction in proceeds, the
business's required returns must be greater to compensate for the additional costs.
4
The price of preferred equity will fluctuate as similar-risk investments’ yields vary. Because of the similarities of certain preferred
equities and bonds, these preferred equities’ prices will tend to fluctuate with the generic concept of “interest rates”.

Cost of Capital Navigator: U.S. Cost of Capital Module 1 of 2

 common equity, but riskier than debt instruments.
• Debt capital: The cost of debt capital is the expected return to debt (e.g., bond)
investors. Usually referred to as simply cost of debt. Note that the cost of debt is
estimated prior to the tax effect (without regard to the tax shield). Debt capital is
generally less risky than preferred equity and common equity.
• Weighted average cost of capital (WACC): The cost of capital to the overall
business is commonly called the WACC. WACC represents the market-
capitalization-weighted cost of capital for both equity holders (both common and
preferred) and debt holders. WACC is sometimes referred to as “blended cost of
capital”, or simply “overall cost of capital”. WACC is typically estimated on an after-
tax basis, as explained later in this chapter.

Data and methodology in the Cost of Capital Navigator can be used to estimate the cost
of common equity capital. Estimating the costs of the other components of the capital
structure – preferred equity capital and debt capital – is typically more straightforward
than estimating the cost of common equity capital. This is because the cost of capital (risk)
of fixed-income securities (bonds) and fixed-income-like securities (preferred stocks) are
usually directly observable in the market, while the cost of equity capital is not. 5

5
To learn more about the cost of preferred capital and debt capital, see Pratt and Roger J. Grabowski, op.cit.: Chapter 20, “Other
Components of a Business’s Capital Structure”.

Cost of Capital Navigator: U.S. Cost of Capital Module 2 of 2