Cost of Capital Unit 4 FM

Cost of Capital Formula
The cost of capital represents the funds required to construct projects such as building a factory or mall.
The cost of capital combines the cost of debt and equity.
To complete the project, funds are required, which can be arranged either by taking debt loans or by
own equity that is paying money self. Many companies use debt and equity together for the weighted
average of all capital, known as (WACC) Weight average cost of capital. It is also an opportunity cost of
investment that means if the same amount has been invested in other investments, the rate of return
one could have earned is the cost of capital.
The simple formula for the cost of capital is the sum of the cost of debt and equity. The formula for Cost
of Capital can be written as:-
Cost of Capital = Cost of Debt + Cost of Equity
Cost of Capital Formula – Example #1
Suppose a company started a project of shopping mall construction for that it took a loan of $1,000,000
from the bank, the cost of equity is $500,000. Now, one has to calculate the cost of capital for the
project.
In brief, the cost of capital formula is the sum of the cost of debt, the cost of preferred
stock, and the cost of common stocks.
Cost of Capital = Cost of Debt + Cost of Preferred Stock + Cost of Equity

Where,
 Cost of Debt: The cost of debt is the effective interest rate the company pays
on its current liabilities to the creditor and debt holders.
Cost of Debt = Interest Expense (1- Tax Rate)
 Cost of Preferred Stocks: The cost of preferred stock is the rate of return
required by the investor.
Cost of Preferred Stocks (kp) = Dividend (Do) / Current Market Price(P0)
 Cost of Equity: Cost of equity is the rate of return an investor requires for
investing equity into a business. There are multiple types of cost of equity and
model to calculate the same, they are as follows:-
Capital Asset Pricing Model
It takes risk into consideration, and formula for the same:-
Ri = Rf + β * (Rm – Rf )
 Ri – Expected return on asset.
 Rf – Risk free rate of return.
 Rm – Expected market return.
 β – Measure of risk.
If
 β < 1, Asset is less volatile.
 β = 1, Asset volatility is the same rate as market.
 Β > 1, Asset is more volatile.
Dividend Capitalization Model
It is applicable that pay dividends also assume that dividends will grow at a constant
rate.
Re = D1 / P0+ g
Where,
 D1 – Dividends/Share next year
 P0 – Current share price
 g – Dividend growth rate
 Re – Cost of Equity
As we know,
Cost of Capital = Cost of Debt + Cost of Preferred Stock + Cost of Common Stocks
Cost of Capital = Interest Expense (1- Tax Rate) + D0 / P0+ Rf + β * (Rm – Rf )
Or
Cost of Capital = Interest Expense (1- Tax Rate) + D0 / P0 + D1 / P0 + g
Weight average cost of capital = wd rd + wp rp + we re
Where,
 wd – Proportion of debt in the capital structure.
 wp – Proportion of preferred stock in the capital structure.
 we – Proportion of common stock in the capital structure.
 rd – Cost of debt.
 rp – Cost of preferred stock.
 re – Cost of equity.
Now, let us see an example based on this formula.

Suppose a company wants to raise capital of $100,000 to expand its business for
that company issue 8,000 stocks with a value of $10 each where the rate of return
on equity is 5%, which have generated fund of $80,000 and it borrowed loan from
bank of $20,000 at a rate of interest of 10%. The tax rate applicable is 30%.
Weight average cost of capital is calculated as:
Weight Average Cost of Capital
Weight average cost of capital is a calculation of a company’s cost of capital in which
each category of capital is proportionately weighted. In short, it computes the cost of
each source of capital. In WACC, all capital types are included, like common stocks,
preferred stock, etc.

The formula for Weight Average Cost of Capital can be written as:-
WACC = E/ V * Re + D/ V * Rd * (1 – T)
 Re – Cost of Equity
 Rd – Cost of Debt
 E – Market value of Equity
 D – Market value of Debt
 E/ V – Percentage of financing equity
 D/ V – Percentage of financing debt
 T – Tax rate
Let’s see an example to calculate WACC.

An investor wants to calculate the the WACC of two companies, Apple and Google.
Below is the various required element for both companies. Let the beta of stocks
be 1.2, and the credit spread 2%.

Formula to calculate the Cost of Equity is:
Cost of Equity (ke) = Rf + β (E(Rm) – Rf)

Formula to calculate the Cost of Debt is:
Cost of Debt = (Risk Free Rate + Credit Spread) * (1 – Tax Rate)
Cost of Debt of Apple

Uses of Cost of Capital Formula
There are multiple uses of the cost of capital formula. They are as follows:-
 Cost of the capital formula is used for the financial management of a company.
 An investor uses it to choose the best investment option.

 Cost of Capital formula also helps to calculate the cost of the project.
 WACC is used to find the DCF valuation of the company.

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Cost of Capital Formula

Cost of Capital = Cost of Debt + Cost of Equity

Cost of Capital Formula – Example #1

stock, and the cost of common stocks.

Cost of Capital = Cost of Debt + Cost of Preferred Stock + Cost of Equity

on its current liabilities to the creditor and debt holders.

Cost of Debt = Interest Expense (1- Tax Rate)

required by the investor.

Cost of Preferred Stocks (kp) = Dividend (Do) / Current Market Price(P0)

model to calculate the same, they are as follows:-

Capital Asset Pricing Model

It takes risk into consideration, and formula for the same:-

 Ri – Expected return on asset.

 Rf – Risk free rate of return.

 Rm – Expected market return.

 β = 1, Asset volatility is the same rate as market.

 Β > 1, Asset is more volatile.

Dividend Capitalization Model

 D1 – Dividends/Share next year

 P0 – Current share price

 g – Dividend growth rate

Cost of Capital = Interest Expense (1- Tax Rate) + D0 / P0+ Rf + β * (Rm – Rf )

Weight average cost of capital = wd rd + wp rp + we re

 wd – Proportion of debt in the capital structure.

 wp – Proportion of preferred stock in the capital structure.

 we – Proportion of common stock in the capital structure.

 rp – Cost of preferred stock.

Now, let us see an example based on this formula.

Cost of Capital Formula – Example #2

Weight average cost of capital is a calculation of a company’s cost of capital in which

each category of capital is proportionately weighted. In short, it computes the cost of

preferred stock, etc.

 E – Market value of Equity

 D – Market value of Debt

 E/ V – Percentage of financing equity

 D/ V – Percentage of financing debt

Let’s see an example to calculate WACC.

Cost of Capital Formula – Example #3

be 1.2, and the credit spread 2%.

Cost of Equity (ke) = Rf + β (E(Rm) – Rf)

Cost of Debt = (Risk Free Rate + Credit Spread) * (1 – Tax Rate)

Cost of Debt of Apple

 An investor uses it to choose the best investment option.

 WACC is used to find the DCF valuation of the company.

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